Did Taxes Cause the Financial Crisis?

CAMBRIDGE – After the financial crisis erupted in 2008, many observers blamed the crisis in large part on the fact that too many financial firms had loaded up on debt while relying on only a thin layer of equity. The reason is straightforward: whereas equity can absorb a business downturn – profits fall, but the firm does not immediately fail – debt is less forgiving, because creditors do not wait around to be paid. Short-term creditors cash out or refuse to roll over their loans, denying credit to financially weakened firms. Long-term creditors demand to be “made whole” and sue. Without cash, the firm fails.

Financial firms in the United States pay about 34% of their profits in taxes, and, while they can deduct interest payments to creditors from taxable income, equity is not taxed as favorably. Most countries have similar tax preferences for debt over equity, thereby encouraging financial and other corporations to use more debt, as financial analysts have long known.

And yet the argument that this tax preference for debt played a role in the financial crisis – and that it remains an ongoing risk to financial stability – was quickly rejected. After all, the tax preference for debt has existed for a long time, and nothing heightened it before the crisis hit. On the contrary, if anything, the tax preference has decreased somewhat over time. And the crisis was quite clearly tied to the explosion in risky mortgage-backed securities in the US; when the market abruptly realized that these securities could not be paid off in full, many systemically important financial firms were seen to be much weaker than they had seemed. Catastrophic economic consequences followed.

All of this is true, but, given the possibility of a major overhaul of US corporate taxation, which President Barack Obama has proposed, we should revisit the conventional wisdom concerning the supposedly weak connection between corporate taxation and the financial crisis. Indeed, in my view, policymakers, academics, and the media have rejected too resolutely the idea that corporate taxation played no more than a minor role.

To be sure, the tax preference for debt has been embedded in the economy for a long time, with no financial crises for most of that period. And, yes, tax incentives are not the only – and perhaps not even the most important – reason why financial institutions use a lot of debt and minimize equity. Most important, while reliance on debt made financial institutions riskier, creditors knew that, in a crisis, the government would probably bail out the largest, if not all of them. Government was less likely to bail out equity.

Viewed from this perspective, it is no wonder that the question of how debt is taxed has played a small role in financial-reform packages. Financial institutions fell off the cliff in 2008, it is argued, because they got too close to the edge. Destabilized by too much short-term debt and too much exposure to risky, overvalued, low-quality mortgage-backed securities, they tripped and fell over it. So regulators have focused on command-and-control orders to financial firms to increase their equity, and to reduce the riskiness of their investments.

But consider another way of viewing the crisis and our financial institutions: the financial system was never all that far from the cliff’s edge, even before 2008, because the tax system encouraged financial firms to overload themselves with debt. They generally managed themselves and their risks well, so they did not fall. But then, in the run-up to the crisis, they miscalculated, taking on too much short-term debt and over-investing in risky securities. The added risks pushed the financial system past the tipping point, but the baseline problem was that it always contained too much risky debt.

From this perspective, it becomes clear that the baseline tax-induced risks should not be ignored. The policy consensus has properly focused first on the new risks that were added. But focusing on those added risks should be only the first step; doing so should not lead us to ignore the baseline risks that the tax system creates.

The taxation issue may go deeper. The tax system first encourages financial firms to use more debt than is safe, but there is a parallel effect on non-financial firms and many homeowners. Tax deductions for interest payments encourage them to borrow, too, an issue that has long been understood. But, less obviously, these borrowers then demand more tax-induced lending from financial institutions, because tax benefits make their own use of debt cheaper. Were their demand for debt lower – and, in the case of corporate debtors, were they to rely more on equity – financial institutions would face less pressure to use so much debt themselves.

Much consideration has already been devoted to how to reform corporate taxation in a way that levels the playing field for equity relative to debt; more than 20 years ago, the US Treasury conducted a major analysis and devised a plan to do so. As the Obama administration moves ahead with its new proposals, it should look back at the financial crisis, which provides strong grounds for implementing such a change.