Tax Reform and the Tax Treatment of Debt and Equity
by Simon Johnson, Peterson Institute for International Economics
Testimony submitted to the US House Committee on Ways and Means and the US Senate Committee on Finance for the hearing on "Tax Reform and the Tax Treatment of Debt and Equity"
July 13, 2011
This testimony draws on joint work with James Kwak and Peter Boone. Our updates and detailed policy assessments are available at BaselineScenario.com. The views expressed here are personal and not those of any other organization.
Further Financial Sector Considerations: Why Regulation Is Not Enough
Thinking about debt bias in the financial sector is closely related to the debate on capital requirements for banks.
Capital is not something banks "hold" but rather refers to how they fund their loans—i.e., capital is on the liability side, not the asset side, of a bank's balance sheet.10 Less capital means that loans made by banks are funded with more debt relative to equity. This puts the banks in greater danger of default. In contrast, more equity capital implies more safety—and less risk—for both the equity and the debt issued by the bank.
In principle, capital levels in the US banking system could be increased by regulation. But in practice such measures are unlikely to be sufficient. Partly this is because capital requirements are largely set in the international Basel process negotiations, where the lowest common denominator prevails.11
There is nothing in the Basel III accord on capital requirements—concluded in fall 2010—that should be considered encouraging. Independent analysts have established beyond a reasonable doubt that substantially raising capital requirements would not be costly from a social point of view (see the work of Anat Admati of Stanford University and her colleagues).12
Arguments that equity is "expensive" for banks are either incorrect or self-serving. From a broader social perspective, banks and anyone else providing credit should be financed with relatively more equity and less debt. This would not reduce the availability and growth of credit—rather it would ensure that financial institutions have sufficient "loss-absorbing" capital on their balance sheets. This is what we need for sustainable growth and job creation.
In a free market system—without government guarantees—financial institutions fund themselves with a relatively large amount of equity (30 percent of total assets is not uncommon), because they need a strong buffer against losses. Investors are not willing to fund a bank that is prone to collapse.
But in a system with deposit insurance (and other forms of potential government protection for creditors), the downside risk for one class of investors—retail depositors—is limited or zero. This encourages banks and other financial firms to fund themselves with more debt relative to equity, which means little capital relative to total assets. This increases the upside payoff to equity—i.e., for a given return on assets, the return on equity is higher when things go well. But it also increases the downside returns on equity, creating more volatility and a higher probability that the bank will become insolvent—perhaps with major negative effects on the rest of the economy. Bank executives are paid primarily based on the return on equity, unadjusted for risk.
In effect, big firms in modern financial systems receive a great deal of government-backed implicit insurance, without having to pay for the privilege. This is not only unfair to the nonfinancial sector and to everyone else in the economy, it is also very dangerous—we are subsidizing exactly the kind of behavior (excessively high leverage) that we should seek to discourage.
Rather than requiring banks become small enough, simple enough, or unimportant enough to fail, the Dodd-Frank Act gave regulators new resolution authority to protect the financial system from a collapsing financial institution in a crisis, hoping that fear of being "resolved" would be enough to deter financial institutions from taking excessive risks in the first place. While this is better than nothing, it is highly improbable that authority granted to US regulators over US institutions will be sufficient if a major global bank with subsidiaries in many countries is about to fail.
Dodd-Frank also gives regulators new preemptive weapons they can use against big banks, if they so choose. These include the ability to force banks to draw up plausible "living wills" and to shrink if these wills indicate an unacceptable risk to the financial system. But whether those weapons will ever be used remains a big question mark.
Taxing excessive leverage in the financial sector would be a sensible complement to capital regulation. There is generally no convergence in corporate tax systems across countries so—unlike with real or imagined constraints in the Basel III negotiations—we can set policy that makes sense for the United States.13
A number of European countries have already introduced new taxes on financial institutions—including the United Kingdom, for which the base is liabilities other than Tier 1 capital, insured deposits, and some other items.14 The rate in the United Kingdom will initially be 0.04 percent, rising to 0.07 percent—which is definitely on the low side, if the goal is to tax away any "too big to fail" funding advantage.
Any such tax could go into general revenue and, if the goal is revenue neutrality, could reasonably be used to lower the effective corporate income tax for the nonfinancial sector—for example, by compensating for revenue lost due to the adoption of an allowance for corporate equity in the nonfinancial sector.
Financial crises have major negative consequences for the nonfinancial sector and imposing ad hoc penalties on the financial sector after any crisis is not workable—that is often the moment when banks are least able to pay. Encouraging less reliance on debt by the nonfinancial sector is one way to reduce the vulnerability of the real economy to future financial crises. But the top priority should be taxing excessive leverage in the financial sector.
Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.
1. The extent of tax-induced debt bias for firms depends on the tax treatment of investors and some other details – and not all nonfinancial firms choose to be leveraged – but the general statement holds.
2. See Simon Johnson and James Kwak, 13 Bankers, Chapter 5.
3. In the United States, bankruptcy costs for the nonfinancial sector are generally small. The FDIC resolution process for small- and medium-sized banks is well-run and does not usually have large social costs. And some kinds of financial firms can restructure their debts without big negative impact on the economy (e.g., the recent case of CIT Group). But the failure of large financial institutions can be very disruptive—as the experience of Lehman Brothers shows.
4. See also the May 2010 edition of the IMF's cross-country fiscal monitor [pdf] for comparable data from other industrialized countries. The box on debt dynamics shows that mostly these are due to the recession; fiscal stimulus only accounts for 1/10 of the increase in debt in advanced G-20 countries. Table 4 in that report compares support by the government for the financial sector across leading countries; the United States provided more capital injection (as a percent of GDP) but lower guarantees relative to Europe.
5. Andrew Haldane (Bank of England) and Anat Admati (Stanford University) both refer to system risk in this context as a form of pollution, i.e., a negative social spillover that should be discouraged by regulation and/or taxation.
6. Compared to other industrialized countries, the United States stands out in terms of the extent to which it encourages households to leverage for house purchases. See, for example, figure 1 on page 21 of "Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy," [pdf] International Monetary Fund 2009.
7. See Ruud de Mooij, "Tax Baises to Debt Finance: Assessing the Problem, Finding Solutions," [pdf] International Monetary Fund, Staff Discussion Note, May 2011,. Abolishing the corporate income tax is less appealing, particularly as an increasing number of investors are tax-exempt, including pension funds and foreigners (such as sovereign wealth funds).
8. Leveraged buyouts can potentially contribute to system risk and a "thin capitalization" tax would address this.
9. See Michael Keen, "The Taxation and Regulation of Banks," [pdf] International Monetary Fund, mimeo, March 2011. There is useful background analysis in "Financial Sector Taxation: The IMF's Report to the G-20 and Background Material" [pdf].
10. "Holding capital" is a common phrase that is completely misleading and often causes confusion in the debate—making people think that capital is an asset, rather than a liability.
11. Credible reports indicate that in the Basel III negotiations, France, Germany, and Japan all wanted lower capital requirements than did the United States.
12. Anat Admati, Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer, "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive" [pdf].
13. In addition, taxation can reasonably target high leverage, i.e., excessive debt relative to total assets, which is really what causes systemic risk "pollution." The Basel process has instead pursued risk-weighted capital, which turns out to be a potentially misleading concept—or example, many European banks currently look fine in terms of their tier 1 capital, but only because they have a low or zero risk-weight on bonds issued by their own governments (which now prove to be very risky).
14. See Michael Keen, "Rethinking the Taxation of the Financial Sector," International Monetary Fund, mimeo, October 2010.