The Tax Code and Systemic Risk

Simon Johnson at the New York Times discusses whether tax reform could make the financial system safer, for example, by reducing tax incentives to favor debt over equity which increases leverage in the economy and makes firms more vulnerable to economic downturns as a result. The topic is near and dear to my heart as I presented on May 29, 2009 at the Law and Society Conference in Denver entitled "This Financial Crisis Was Brought To You By The Internal Revenue Code" on essentially the same subject.

Some key points of my paper were these:

1. Aggregate tax rates don't have much influence on economic growth, but incentives to engage in one kind of economic activity rather than another good economic substitute for that kind of activity are extremely influential. For example, historically very specific provisions of the law regarding which kinds of charitable giving are entitled to tax deductions have profound influences on the porportion of taxable gifting made by that means. A wig tax destroyed the wig as a fashion accessory. Tax policy has a strong influence on home ownership levels in mortgage loan to value ratios in Europe and was an important factor in the housing bubble in places like California that lead to the financial crisis.

2. Another important but subtle difference was the tax distinction between obtaining a second mortgages for the non-conventional part of a mortgage loan (i.e. beyond 80% loan to value), and private mortgage insurance. Both protect the first mortgage holder in the same way. But, tax law favored second mortgages over private mortgage insurance during the housing bubble. This was problematic, because the insurance regulation model was much better at regulating systemic downside risk than the mortgage securitization market that governed underwriting of second mortgages.

3. The intense systemic losses that flow from systemic biases towards leverage in the financial sector was illustrated by the history of repeated cycles of mass bank failures during recessions as a result of industry-wide overleverage by investor owned banks until commercial banking was subjected to FDIC regulation, while mutual banks, which gave control to depositors who are a form of lender, effectively transforming them into equity holders, did not experience this frequency of bank failures in economic downturns. Management and ownership downside loss relative to upside gain incentives turn out to be pivotal in the degree of risk that businesses take on in the absence of direct government regulation of capitalization.

4. I also illustrated how a change in government policy in 19th century Japan that changes a system of equity based land finance to a debt financed system of land finance produced a mass wave of foreclosures then.

5. I explored how overleveraging made the housing bubble possible, how that overleveraging was facilitated by non-bank lenders who has strong incentives to in turn leverage their own balance sheets which the FDIC regulation of the commercial banking sector was not there to stifle.

6. The investment banking industry, in turn, poured money into these non-bank lenders making risky decisions in their investing decision because they had turned from an equity financed partner owned structure with a brokerage model to a highly leverage investor owned structure investing on their own accounts, and because they had heads I win, tails you lose incentive stock option and bonus based compensation structures. The shift in the investment banking industry business model was driven in part by the strong tax incentives for debt over equity that drove the investment bankers to seek the deregulatory measures that allowed them to restructure in this fashion.

7. This culminated in every major stand alone investment bank in the United States either going bankrupt or reinventing itself as a regulated commercial bank, in Lehman Brothers, one of the oldest investment banks on Wall Street, which was a key financier of mortgage backed CDOs and credit default swaps, going bankrupt, in the government purchase an 80% stake in the major insurance company AIG, in order to prevent defaults on credit default swaps it issued from destroying the financial sector, and so on. Commercial banks which were barred by the FDIC from acting on tax incentives to overleverage, in contrast, failed at an only slightly elevated rate relatively to other recessions.

8. I explore the fact that one of the reasons that this spread to the real economy with the GM and Chrysler bailouts that followed, was because these firms were vunerable because they were overleveraged. Defined benefit pensions (which look like debt obligations to corporations unlike defined contribution plans) and reliance on bonds rather than stocks for capital were both key factors here.

9. The key culprits in the tax code, in the end were: (1) the corporate tax law debt-equity distinction and incentives, (2) incentive stock option compensation tax incentives that encourage excessive risk taking by public company executives, (3) the home mortgage interest deduction and in particular the detail that it allows deductions up to the full value of the house for second mortagages and vacation homes but not for private mortgage insurance for first mortgage holders who have a greater incentive to be cautious in underwriting.

The take away lessons were that while we have never been successful at preventing recessions from happening, that tax code reform that ends tax subsidies of debt relative to equity and that would encourage executive compensation and entity financing approaches that give decision makers a reason to fear downside losses would lead to a more resiliant, less risk biased economy.

Eliminating the bias that favors debt over equity in combined C corporation and shareholder income taxation has been a darling of academic economists and tax lawyers (for good reason) for decades, particularly after the General Utilities doctrine removed the best tool for circumventing the distinction. Incentive stock options have always been a concern of those worried about unfairly low tax rates for the rich but also have impacts important the systemic risk in the economy on corporate executive decision making by removing downside risk while rewarding upside gain for executives. There is more than one way to reduce the incentive to overleverage residental real estate and not unduly favor buying with a mortgage over leasing a residence, but restraining the incentives where they are doing the most harm, even without total reform of that area of tax law, would have major stablizing economic effects for the nation.