Votermedia Finance Blog

October 13, 2008

Tax system contributed to financial crisis?

Filed under: Uncategorized — Mark Latham @ 9:34 pm

Does the double taxation of equity push financial firms toward excessive leverage? I think so, but then why don’t I see anyone writing about that? Maybe because I don’t read enough. Please let me know if you are aware of some recent insights on this topic. I plan to research it later, but first would like to share some thoughts on several other issues. Meanwhile, if taxes are a significant factor, it affects the whole discussion so should be recognized at the outset.

Without tax effects and net costs of bankruptcy, the standard Modigliani-Miller analysis says that it doesn’t matter what proportions of debt and equity a firm uses — e.g. see lecture notes from MIT Sloan School course 15.414.

Returns to equity are taxed at the firm level, while returns to debt are not since they are deducted before calculating the corporate income tax. Then at the investor level, equity is taxed by different rules than debt. These rules also differ from one class of investors to another. A growing class of investors (mainly pension funds) pay no tax on either investment type. Investors that are taxed, however, tend to pay lower taxes on equity than debt. The question is whether this tax preference for equity at the investor level is enough to counterbalance the tax penalty at the firm level. I don’t know what the latest research says, but given the growth of pension assets in the past few decades, I guess there’s a net tax preference for debt over equity.

The tax preference looks especially clear if you compare, for example, an investment pool that holds only mortgages versus a 100%-equity-financed corporation that holds only those same mortgages. Except for taxes, the risk and return characteristics of investing in those two entities would be the same, even though the former is called a mortgage pass-through and the latter equity. But I doubt that anyone would create the latter, because it would have to pay corporate tax on the mortgage interest received. Thus the tax system pushes strongly toward securitizing mortgages, in spite of such inefficiencies as the difficulty of managing problem loans.

Tax advantage of debt could be an important part of the reason why financial firms use so much leverage. Firm leverage is strongly correlated with what industry the firm is in (see page 13 here), so the nature of assets being financed is clearly a factor, perhaps because of net bankruptcy costs and differing asset volatility.

Thus a partial remedy for the financial crisis may be tax reform, to level the playing field between debt and equity. This is only a long-term response, for two reasons. It would help prevent a recurrence of the crisis, but wouldn’t solve the urgent short-term problem of stabilizing the system now that financial firms are in trouble. And tax reform is notoriously difficult to achieve, given the complex web of established political and commercial interests. These may be the reasons why I don’t see people writing about the tax system as a cause and cure of the crisis. Nonetheless, I think it deserves consideration as a factor likely to affect any crisis response strategy.

When I wrote “How To Transform a Failed Japanese Bank” ten years ago, I thought we could change the tax rules for only a few recapitalized banks at a time. We could level the debt-equity playing field for them without revamping the entire tax system, while keeping their average cost of capital about the same as the rest of the banks. Then if that worked well, we could gradually move more banks (and other firms) to the new tax rules. The urgency of reviving the financial system might overcome political resistance to tax reform, especially if the reform started small. But I no longer like the particular design I proposed, and can’t think of a satisfactory one. One fundamental problem for this segmented reform approach is that unless the government restricts firms’ freedom to choose what businesses to undertake, firms in the new tax system may migrate toward businesses that use less leverage. They would then have an unfair tax advantage over existing-system firms in similar businesses.

So I’ll put tax reform aside for now, and move to more immediately practical response strategies.

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