There are several ways that changes to the tax laws are typically evaluated:
* How much revenue does the change produce or reduce?
* What are the distributional effects of the tax provision? Who are the winners and losers?
* What are the administrative and compliance costs associated with the tax provision relative to the revenues associated with the tax provision?
* Do the incentives created by the tax provision improve economic efficiency or do they lead to less efficient economic outcomes?
* Do the combined effects of the tax provision promote or do they discourage economic growth?
One perspective that is underappreciated in evaluating tax reforms is their impact on systemic risk in the economy, despite the fact that tax laws can have a powerful effect there.
Systemic risk matters. If there is any lesson that the past century or two of global economic history has taught us, it is that business cycles are inescapable. There will be booms and busts no matter how hard policy makers try to smooth them out. Most recently, in the United States, we were reminded of that fact when a long period of economic growth and shallow recessions was interrupted by the financial crisis, the worst economic downturn since the Great Depression.
It is the factor that allows whole industries and regional housing markets, for example, to collapse simultaneously when a tipping point in the economy is reached.
And, while we may not be able to prevent business cycles, it isn't unreasonable to think that the proper economic incentives, particularly in the tax code, can make our economy more robust, so that periods of falling GDP topple a smaller share of businesses, produce fewer layoffs and send fewer people into bankruptcy.
While the U.S. is finally starting to recover from the financial crisis, weak economies worldwide are facing intense public finance crisises and the creditworthiness of sovereign debts from a whole wave of these countries is plummeting.
The United States income tax system has a number of provisions that work together to magnify systemic risk in the U.S. economy. In particular, they encourage household to make "mixed bets" in the economy by simultaneously encouraging households to take on levels of debt higher than would make sense in the absence of tax incentives, and encouraging households to invest the assets that are freed up by continuing to have debt in financial market investments that are relatively volatile.
The single biggest tax code provision that favors debt is the mortgage interest deduction, including the deductions for home equity loans and second homes. A secondary tax code provision that favors debt is the student loan interest deduction. Both of these incentives are further amplified by interventions in the commercial lending market with loan guarantees and government chartered entities designed to make loans for these purposes more easily available than they would otherwise have been.
But, it is not just that there are tax incentives to leverage. There are also tax incentives to invest in the financial markets for households. A middle class household pays almost no income taxes on capital gains and qualified dividends from financial market investments. And, a middle class household can invest effectively all funds available out of income for savings in tax preferred retirement and education savings accounts.
When the economy is growing, these incentives are good policies for households to adopt. Growth in housing values, even merely at the rate of inflation, produce disproportionate gains in home equity for leveraged homeowners. Effectively income tax free financial investments for retirement or education in excess of the interest rates paid on tax deductable mortgages increase household wealth relative to paying off mortgage debt.
But, when the economic is in a bust phase, the mixed bets facilitated by incentives to leverage and invest in the financial markets with invested assets are bad policies for households to adopt. Leverage amplifies the declines in home equity that arise from falling housing prices. And, in the down phase of the business cycle, financial investments frequently lose value (often dramatically and in short periods of time) just when people need to tap their investments to meet their costs of living (hence causing them to buy high, and sell low) relative to paying off the debts that freed up the assets that were invested.
Economic historians will note that in the long term, indeed, for any time period of fifteen or twenty years or so or longer, the financial markets have been a good investment. Likewise, housing values have a strong tendency to mirror the rate of inflation over sufficiently long time periods. In short, for households that are able to weather economic downturns while still making their mortgage payments and not raiding their savings - in short - for households that manage to avoid more than very brief periods of unemployment even during economic downturns, a strategy of mixed bets seems like a sensible thing for the tax code to encourage in order to help households build wealth.
But, large numbers of households, particularly in a severe economic downturn, do experience periods of unemployment and even if they do remain employed, experience irregular incomes. This is particularly true in the small business sector. Small businesses may lead the economy in job creation during booms, but they also lead the economy in job destruction during busts. And, small business owners, who generally aren't even able to enjoy any counterpart to our nation's miserly unemployment insurance program when their incomes plummet due to downward business cycle trends, are particularly vulnerable if they heed the incentives of the tax code to make the kind of mixed bets that make sense only for households with extremely secure incomes such as government employees and core employees of big businesses.
During busts, people who have cyclical or insecure incomes lose their homes to foreclosure (again forcing them into buy high, sell low market timing strategies), pull money out of financial investments at times when asset prices are low and penalties designed to keep people in tax preferenced investments are incurred, lose their vehicles to repossession, forgoe health insurance possibly leading to permanent negative health effects from delaying treatment for medical conditions, and in the face of economic pressure see their marriages fall apart and may make decisions that compromise their children's future prospects.
If the tax code had neither deductions for interest expenses like mortgage interest and student loan interest, nor tax incentives to invest in the financial markets like tax preferrenced retirement savings accounts, tax preferrenced education savings accounts, and preferences for capital gains and qualified dividends, far more people would have far fewer savings in financial assets, but would also have much less debt.
A mass shift toward this kind of "unmixed bets" in households would reduce systemic risk in the U.S. economy during economic downturns. Fewer people would have mortgages at all, and those who did would have much smaller mortgages, so more people who suffered serious short to medium term income shocks would be able to weather downturns without being forced to lose their homes. Even in cases where households couldn't continue to make regular mortgage payments even with smaller mortgages, much lower loan to value ratios that could be refinanced more easily from hard money lenders (or paid off with non-distressed home sales) if necessary to avoid foreclosures, even in periods where housing prices were falling.
It is much harder to lose an investment made in paying off mortgage debt than it is to lose an investment in stocks and bonds.
A shift away from leveraged financing of homes would also make it harder for housing prices to stray far from ability to afford it, discouraging situations like the real estate bubble that precipitated the financial crisis.
Proof that policies to reduce systemic risk and leverage can help an economic sector become more robust in economic downturns, even when business cycles themselves cannot be tamed, is evidence from FDIC regulation of the commercial banking industry. Prior to FDIC regulation, half of commercial banks or more shuttered their doors during a serious economic bust. After FDIC regulation, the biggest component of which was to require commercial banks to limit the amount of leverage that they took on at the entity level, the percentage of commercial banks that failed, even in the financial crisis, dwindled to tiny single digit percentages and prevents the contigon of a failed entity from migrating throughout the economy.
Tax policies that similarly encouraged households to deleverage, rather than to make mixed bets on both leveraged housing purchases and volatile financial investments at the same time, would likewise not only increase the survivability of economic downturns for tens of millions of middle class households, particularly for working class families and small business owners who have less stable incomes, and would also help the economy overall weather recessions more robustly but preventing the economic distress of these households from propogating across other parts of the economy.
Thus, the path to an "ownership economy" is via economic policies that discourage household borrowing, and discourage financial market investments for households that have household debt.
Other policies that would encourage lenders to be more flexible during situations like a housing bubble collapse, such as allowing families in bankruptcy to "cram down" home mortgages to the value of the collateral and serve the bankrutcy modified loans, just as big businesses in Chapter 11 bankruptcies and wealthy individuals with second homes who are in bankrutpcy can under current law, would further advance the policy of having a more robust economy during economic downturns.
If we are to have preferences for investment in the tax code at all, perhaps those preferences should encourage households to develop what almost every financial planner puts first ahead over financial market investments in a financial plan, the establishment of a savings account in a risk free FDIC insurance commercial bank account worth three to six months or more of the household's income, to allow the household to weather brief job losses, income volatility for the self-employed, and medium sized unplanned expenses like the defense of a DUI prosecution, a major medical or dental bill, a miscalculated income tax bill at year end, or an unanticipated necessary repair to a home or a vehicle.
A tax code provision excluding all interest on, for example, up to $100,000 of FDIC (or equivalent) insured savings would do far more to support a robust economy during economic downturns than tax incentives for investments in stocks and bonds via special retirement accounts, education savings accounts and reduced rates of taxation on stocks and bonds. This quick and dirty exclusion from income would also help solve the dilemna whereby the after tax rate of return on a savings account is frequently less than the rate of inflation, causing taxes to be owed on an investment that is usually a break even or money losing investment in real dollar terms. And, it would provide a behavioral cue to encourage people to avoid the risks of uncompensable losses from theft and casualty associated with holding significant wealth in the form of currency rather than bank deposits (and simultaneously making funds that would otherwise have been held as currency available for others to invest in ways that promote economic growth).
If the exclusion was quite limited in dollar amount, didn't not have the involved account management features of retirement and education and medical savings accounts, and limited to risk free investments that the market insures will always have the lowest returns, the cost of this tax benefit could be very modest.
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