Paul L. Caron

Saturday, June 20, 2009

The Tax Causes of the Economic Crisis

Forbes:  Taxes and the Crisis, by Bruce Bartlett:

It's important to understand the origins of the economic crisis so that the correct policies can be implemented to end it and prevent its recurrence. Thus far, most attention has focused on monetary and regulatory policy. But a new study from the International Monetary Fund [Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy] argues that tax policy played an important role as well.

The IMF study doesn't cite any particular tax changes over the last few years that were responsible for generating the economic crisis. However, it points to a number of features of the tax code that contributed to it.

The most important problem identified by the IMF is the favorable tax treatment of debt and the punitive taxation of corporate equity in our system. This problem is exacerbated by a higher corporate tax rate in the U.S. than exists in most other countries, which magnifies the benefits of debt relative to equity. ...

Of course, the bursting of the housing bubble was primarily responsible for the recession. And every homeowner knows the tax benefits of housing. Mortgage interest is tax-deductible, as are property taxes. But this is really just part of the tax benefit to home ownership. The real benefit is non-taxation of what economists call imputed rent--the rent homeowners in effect pay themselves. ... Another enormous benefit to home ownership that the IMF study mentions only in passing is the effective non-taxation of capital gains on home sales. ...

Finally, the IMF study mentions two other tax factors that may have contributed to the economic bubble.

First, the compensation of private equity and hedge fund managers is "carried interest" that is taxed as long-term capital gains rather than wages--15% instead of 35%. This may have encouraged too many people to start companies that were in the business of making risky investments. The Obama administration has proposed treating carried interest as ordinary income.

Second is the tax treatment of executive compensation. In 1993, Bill Clinton and a Democratic Congress enacted a law prohibiting businesses from deducting cash wages paid to one person in excess of $1 million. But incentive pay was exempted from this provision. The result was that companies started paying their bosses largely with stock options. This led to an explosion of pay for corporate executives and may have encouraged them to take actions that would temporarily boost share prices at the expense of long-term profitability.

Among the tax changes that would improve matters are a reduction in the top corporate rate, which would lower the burden on equity and make interest deductions less valuable. Another would be to allow corporations a deduction for dividends paid. Better still would be full integration of the corporate and individual income taxes--treating all shareholders as if they are members of a partnership, with all the corporation's gains and losses attributed to them in proportion to their share ownership.

The best action would be a tax reform that eliminated the deductibility of interest altogether and also eliminated taxation of interest income. This would discourage debt and encourage saving, something this country is going to need a lot more of once the crisis is past.

See also Jeffrey M. Lipshaw (Suffolk), The Epistemology of the Financial Crisis: Complexity, Causation, Law, and Judgment.

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