Print
E-MailMark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law. This post is based on an op-ed by Professor Roe and Michael Tröge that was published today in The Wall Street Journal, which can be found here.
In conjunction with his State of the Union address, President Obama reanimated the idea of taxing big banks’ debts to help stabilize the banking industry and prevent future financial crises. The administration argues that the new tax would discourage banks from taking on too much risk by making it “more costly for the biggest financial firms to finance their activities with excessive borrowing.”
The president’s bank-tax proposal is unlikely to gain traction in the new Congress, just as similar proposals from the administration in 2010 and, last year from the now retired Rep. David Camp (R., Mich.), did not move forward. But even if it became law, it wouldn’t put a sizable dent in bank debt. The reason is simple: The existing tax system strongly encourages debt finance and the proposed new tax will not fundamentally change this.
Today interest payments on debt are tax deductible, whereas dividends to stockholders have to be paid out of after-tax income. Corporate taxes therefore increase the cost to banks of equity but not the cost of debt. The tax effect of the existing deductibility of interest is up to 10 times stronger than the president’s new proposal. Not surprisingly, similar small taxes on debt in European countries have only modestly affected banks’ capital structure.
The issue should not be so much whether banks should be taxed more, but whether smarter taxes, yielding the same revenue, can make the financial system safer.
Large banks’ debt is favored not just by the tax system but also by an implicit government guarantee. Equity investors were wiped out in most failed institutions during the 2008 financial crisis and will likely be wiped out again in a new crisis. Creditors, however, assume that government is likely to bail them out—again—in a future crisis, if that’s what it takes to avoid damage to the real economy. This makes bank debt easier to sell than equity.
Together these factors explain why banks adopt an overly risky capital structure and fiercely resist regulators’ attempts to impose higher equity levels. Creating new tax incentives to favor equity financing over debt financing would reduce the conflict between regulators and banks and could substantially contribute to the stability of the financial system.
But while taxing risky debt will mean we’ll have less risky debt—which we favor—a small tax on debt will only make the system slightly safer. To make tax reform work well here it needs to make equity much more attractive to banks than it is now.
There are several ways to do this. A simple way would repeal the corporate tax for banks—which penalizes banks’ safety-enhancing equity—and replace it with a tax on debt. This tax could be calibrated so that banks would typically pay the same amount, before and after the change. For a well-capitalized and profitable bank that would be a tax of about .5% on debt, which is seven times higher than the president’s proposal.
A better way would be to make the cost of equity tax-deductible in the same way that the cost of debt is deductible today. This system, used in Austria, Belgium, Brazil, and Italy, seems to have discouraged overly aggressive debt financing. To make the change revenue-neutral, the deductibility of debt would be reduced or a tax on debt added. The key factor is to favor equity and disfavor debt; the current tax system does the opposite.
True, a tax deduction for the cost of equity isn’t intuitively appealing if one thinks of stockholders as owners. But the cost of equity is an expense to the organization, just as an owner’s salary would be. Banks raise funds from three main sources—debt, deposits and equity, each of which has to be paid, typically via interest or dividends. These returns to investors are a cost to the bank, which then makes money by lending the funds out. Making the cost for each source of funding tax deductible and only taxing economic profit therefore makes perfect sense.
Finally, revenue-neutral tax reform that lightened the burden on equity has some realistic chance to pass. Banks should not oppose it vociferously, or perhaps at all, as they would write the same-sized check to the tax authorities. True, any major tax change generates opposition—but the tax deductibility of equity, aimed at stabilizing the banking system, has a bipartisan political chance and needn’t be dead on arrival.
