The cover piece of last week’s The Economist concerned what it called “subsidies” that encourage borrowing, stating that these are a dangerous flaw at the heart of the world economy. The article is misguided in its objective, its reasoning is flawed – in some cases outright fallacious – and some of its underlying principles are simply outrageous.
The stated objective of The Economist’s piece is to make the case for eliminating incentives to excessive leverage that undermine the financial system. This ignores the simple fact that the system’s instability stems from its design rather than from the amount of credit it grants. Over the last hundred years, the total leverage of the financial system – particularly banking – has increased constantly as required reserves progressively decreased; to the point where at the beginning of the ongoing crisis many of the world’s largest banks, especially in America, had reserve ratios close to 2%. This contrasts with ratios of 25% at the end of the 19th century and 10-15% throughout most of the 20th century. Other developed economies had ratios as high as 20% as recently as the 1960’s. Modern regulatory requirements changed the focus from required reserves to risk adjusted capital requirements. As the article itself mentions, these requirements have been reinforced during the crisis, although still only a fraction of what reserve requirements were before agreements such as Basel came along. Like with tango, it takes two parties to make a loan agreement. If banks are providing too much credit to the point of becoming unstable when payment defaults rise, this is a consequence of their ability – by design – to do so. As Viral Acharya and Julian Franks noted in their 2008 article on the role of government guarantees, the banking system became complacent with its internal perception of its own risks and failed to adequately budget its required return on capital. It did so at its own peril, that of its shareholders and also of taxpayers asked to bail out failing banks. Failing to recognise this reality will not help bring stability back to the sector.
The main flaw in The Economist’s reasoning is in considering interest deduction in taxes for corporations as a “subsidy”. The favouring of interest in capital structure is a result of the corporate tax. As interest is an expense of doing business, the higher the corporate tax rate, the higher the tax shield. But this is not a “subsidy”. If corporate profits were wholly taxed at the time of dividend distribution, the incentive from tax shields would be zero. Also, this view that tax shields incentivise excessive leverage are a rather naive and narrow take on the Miller-Modigliani theorem. The reality is that too much debt increases the risk to shareholders therefore raising the required return on equity. This acts as a break on the incentive for leverage. As already noted, if a firm going under from too much debt puts pressure on the financial system, this is a result of too little capital or reserves of banks. The system should withstand the normal failures of over indebted corporations. If we’re going to be so radical as to try to orchestrate a fundamental change in corporation tax all over the world, then it would be much better to tackle it from the perspective of eliminating double taxation and simplifying the tax system by taxing shareholders rather than firms.
The second flaw is conflating this issue of corporate taxes with tax incentives for mortgages. While a case can be made against interest deductions in mortgages, the truth is – as The Economist itself recognises – that home ownership statistics are relatively indifferent to the ability to deduct mortgage interest in the personal income tax; that is, countries with no tax breaks have similar home ownership rates to countries that have them. Again, in view of the article’s objective of bettering the financial system’s stability, it’s safe to say that episodes such as the sub-prime crisis were little or not at all created by the existence of these tax breaks. So many other factors, widely discussed and dissected during the last few years, contributed heavily to the crisis, that focusing on mortgage tax breaks seems pointless.
There are other, smaller, flaws. For example, the piece states that most of the tax breaks accrue to the wealthy, therefore increasing inequality. But at the same time it says that house prices are higher because of the distortion. Now, while wealth inequality will be nominally higher with the breaks, due to higher prices, the net effect should actually be reduced disposable income inequality from the same cause. You can’t have your cake and eat it. If the wealthy are overpaying for their property, they will be worse off in terms of their disposable income. Also, their increased wealth will be illiquid and prone to crashes. We should be careful about measuring wealth inequality in both paper and housing bubbles.
This is where the article becomes jarring. The whole piece focuses on forgone government tax receipts due to the tax shields and breaks. It goes as far as comparing the forgone taxes to government spending items, basically assuming in its argument that those potential revenues were the government’s to begin with, to spend where it saw fit. From a supposedly economically liberal newspaper, this tax and spend attitude is surprising, to say the least. Government “need” doesn’t give a blanket moral license for iniquitous taxation. Changing the way interest – as a business expense – was always deducted when calculating taxable profits is so dramatic a shift that a through moral justification is required. The Economist fails to provide one. The financial arguments are flawed, the behaviour incentive arguments are patronising and the government “need” argument ridiculous. On the other hand, while reasonable, the issue of eliminating mortgage interest deductions in personal income taxes is not obvious. The rationale for these breaks is not weak. In the presence of property and capital gains taxes, differentiating between home buyers according to how they finance their purchase is a compelling argument. To reverse the present system requires also a compelling argument.