Why Do We Subsidize Debt?

| Mon Feb. 8, 2010 2:41 PM EST

I talk about leverage as the source of all evil in the financial sector fairly frequently, but it's been a while since I've had a post reminding everyone about the tax treatment that makes debt so attractive. Today, Pete Davis revisits this issue:

The corporate income tax deduction for interest produced a -6.4% tax rate on debt financed investments, while the double taxation of equity income (dividends and capital gains) produced a 36.1% tax on equity financed investments according to this 2005 Congressional Budget Office study. See Table 1. That negative tax rate is the root of the fiscal crisis. Taxpayers paid a large subsidy for Wall Street investors to take those risks.

....The hard part of tax reform is that you have to raise taxes on those getting the subsidies. There are far fewer of them than the many taxpayers who stand to get slightly lower tax rates, so Wall Street corporations will finance the lobbying to kill tax reform before it has to chance to prevent the next financial crisis. We'll end up with watered down quick fixes at best, and the roots of the next financial crisis will remain in the Tax Code.

I'm not sure that I buy the tax code as the "root" of the financial crisis, but it's certainly a contributing factor — and at the very least, removing its tax favored status would remove some of the incentive for the enormous gearing that made the housing bubble so catastrophic. If we want to address leverage abuse, this is one of the arrows that should be in our quiver.

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