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Thursday, September 20, 2012

NY Times: Distortion in Tax Code Makes Debt More Attractive to Banks

NY Times DealBookNew York Times DealBook:  Distortion in Tax Code Makes Debt More Attractive to Banks, by Jesse Eisinger (ProPublica):

[B]anks pay taxes, but they pay a lot less thanks to a giant and underappreciated distortion in our nation’s tax code. Moreover, this tax code distortion makes the financial system and the economy more fragile, prone to bankruptcies and runs. Banks profit, and the economy teeters. Great bargain, huh?

It’s the tax code’s favoring of debt over equity.

For businesses, debt interest payments are tax deductible; equity payments, like when a company pays out a dividend, are not. At the margin, this encourages entities to take on more debt than they otherwise would, as Steven M. Davidoff noted in a Deal Professor column earlier this year. More debt not only makes companies more vulnerable to bankruptcy but also makes investors more susceptible to panics, when they withdraw their capital en masse. More equity would make the world more stable.

“The worst thing the tax code can do,” says Victor Fleischer, a tax specialist at the University of Colorado, “is to make it harder to use a sensible capital structure.” Mr. Fleisher, a contributor to The New York Times DealBook, testified in front of Congress last year about this problem.

This distortion is well known. President Obama, in his tax reform proposal, mentioned it, though he didn’t make any specific proposal about what to do about it. The Republican candidate, Mitt Romney, is proposing substantial tax cuts with the loss of revenue made up with the closing of loopholes. He has yet to specify any of those loopholes, but corporate debt interest deductibility hasn’t been in the conversation. ...

Are there solutions to this distortion?

There are two choices: reduce or eliminate interest deductibility or introduce some deduction for equity. Neither seems particularly feasible for some time. ...Mr. Fleischer suggests that one way to limit the distortion would be to eliminate the deduction to the extent a financial institution exceeds a ratio of debt-to-equity of 5 to 1. If a bank has borrowed $6 for every $1 in stock, then it doesn’t get to deduct the interest payments on that extra dollar of debt. That would make debt more expensive and make banks less inclined to borrow as much.

And it would help stop banks from being moochers.

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Comments

Cleaner way to limit the deduction is to allow a deduction only for the risk free interst rate at which the federal government borrows long term. The interest above that is an insurance premium paid to cover the creditors risk of default. That is an equity feature, only the risk free interest rent is in the nature of an expense that will be paid in any event.

Posted by: Calvin H. Johnson | Sep 20, 2012 3:12:24 PM