It's Time to Stop Favoring Debt Over Equity

The tax code makes debt much more attractive than equity
The IRS building in Washington Photograph by Andrew Harrer/Bloomberg

Taxes are a hot topic these days in the contest for the presidency. At the moment, you can’t escape the wide divide between the rivals for the White House over taxes. It’s part of their drive for votes. Yet the pressure to deal with the federal government’s yawning deficit and steep debts will push whoever wins on Nov. 6 toward embracing some form of major tax overhaul. All the major bipartisan blueprints for improving federal finances produced in recent years—including that of the widely touted Simpson-Bowles commision—highlight the critical role of comprehensive tax reform.

Fundamentally rewriting the tax code is easy to call for and tough to do. The last major reform came a quarter-century ago with the 1986 Tax Reform Act during the Reagan administration. Differences over tax policies have divided the electorate since the early days of the Republic for the simple reason that taxes involve difficult policy trade-offs between encouraging growth and ensuring equity. The transition toward a comprehensive tax overhaul is always perilous for legislators—businesses and families have arranged their finances around existing tax code.

This time around, there is an under-appreciated factor that should force legislators toward putting a priority on embracing change: eliminating the incentives in the tax code that favor debt financing over equity. Specifically, companies are encouraged to borrow, since interest payments are deductible, while the cost of equity capital isn’t. Homeowners that itemize get to deduct their mortgage interest payments and home equity loans. Yet too much debt lay at the core of the financial crisis.

True, the tax code’s incentives to borrow didn’t cause the 2008 credit crisis that eventually wiped out trillions in wealth and cost millions their jobs. Instead, the tax code encouraged a reliance on debt over time that left homeowners and business vulnerable. Daniel Shaviro, tax authority at New York University Law School, draws an intriguing analogy with a famous scene in the movie Zoolander. A comedy about the fashion industry, Zoolander (played by Ben Stiller) and his male model friends are playfully spraying each other with gasoline at a gas station to the upbeat pop tune, Wake Me Up Before You Go-Go. A clueless gasoline-soaked model lights a cigarette to look cool, igniting an explosion. “The tax system leaves a lot of gasoline—debt—on the floor,” says Shaviro. “The crisis is like someone setting off a spark.”

Take the deductibility of mortgage interest. Economists and tax scholars have long wanted to eliminate it. The basic complaint is that the tax break clearly encourages taking on debt to own a home, especially among high-income itemizers. The debt at the core of the financial pressure on so many middle class households in recent years has been deductible home equity loans. Households have made painful progress deleveraging their balance sheets since 2008. For instance, the financial obligations ratio—principal and interest payments on debt, as well as other monthly expenses such as leases and rental payments as a percent of disposable personal income—fell from a high of almost 19 percent in 2007 to a fraction over 16 percent, according to the Federal Reserve. Why keep on the books a tax break with this message: Take on more debt and enjoy a bigger tax break? It makes no sense to leave the incentive on the books so that people lever up when the good times (eventually) roll.

Business can also deduct interest payments. They don’t get an equivalent deduction for equity financing. The impact of the differential tax treatment is striking. A 2005 Congressional Budget Office report estimated that corporate investments financed with equity are effectively taxed at a 36.1 percent rate while those financed with debt enjoy a negative effective rate of 6.4 percent. A 2007 Treasury Department report noted that the U. S. had the largest disparity between debt and equity effective marginal tax rates in the OECD. “The incoherence in the taxation of capital income has serious economic consequences, including the inefficient encouragement to over-invest in housing and to bear risk, as well as a misallocation of risk,” writes Joel Slemrod, economist and tax specialist at the University of Michigan’s Stephen M. Ross School of Business in a conference paper, “Lessons for Tax Policy in the Great Recession.” As NYU’s Shaviro bluntly puts it, “the corporate tax system is messed up in so many ways.”

There seems to be a sense of greater urgency over creating a level playing field between debt and equity following the global financial crisis. The International Monetary Fund, the OECD, the European Commission, and other institutions with lots of economists on staff have all examined ways to resolve the issue. Two proposed changes in particular come up repeatedly. The first calls for getting rid of the distortion between debt and equity by allowing for the deductibility of both sources of financing. The second is a comprehensive business income tax that achieves the same result by denying interest deductibility at the corporate income tax level.

You aren’t hearing about debt, equity, and taxes as the presidential campaign moves through its final weeks. Nevertheless, once we know the outcome of the election, Congress and the next president should worry much more about tax code favoritism toward debt. History suggests that reform won’t prevent another financial crisis, but it might  limit the downside—a worthwhile, attainable goal. If you doubt that, just ask people who lost their home or job these past few years.

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