Did Taxes Cause the Financial Crisis?

Conventional wisdom has resolutely rejected the view that tax systems' tendency to favor corporate debt over equity contributed to the global financial crisis. But, with the Obama administration planning to overhaul US corporate-tax policy, the tax system's potential impact on financial risk merits further consideration.

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.

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