In The Blogs

Addicted to Debt

| Tue Jul. 14, 2009 9:19 AM PDT

The world has become addicted to debt. Wall Street loves it because you can play far more interesting games with debt than you can with equities. Consumers love it because it makes up for stagnant wages. Investors love it because it gooses their returns.

As a result, there's way too much of it. So how do we cut it down to size? Felix Salmon suggests that although massive regulatory interventions are probably doomed to failure, we could, at a minimum, stop subsidizing debt by getting rid of its tax advantages:

At the moment, companies pay tax not on earnings before interest but earnings after interest — that gives them an incentive to lever up as much as possible. Last year, Steve Waldman had a great post entitled “Eliminate the business interest tax deduction“; it's well worth (re)reading in light of what has happened since.

In general the multi-trillion-dollar edifice of debt financing is predicated on all manner of artificial tax advantages which are given both to borrowers and to fixed-income investors; tax-free municipal bonds and mortgage-interest tax relief are just two of the most egregious examples here.

Forcibly converting mortgages into some kind of shared-equity arrangement where banks get direct exposure to the house price is fraught with difficulty; abolishing mortgage-interest tax relief, however, is easy. And it raises much-needed money for the government as well.

I wouldn't exactly agree that eliminating the mortgage interest tax deduction is easy, but point taken. It's at least within the realm of imagination.

In the past, debt has received preferential tax treatment because it was thought to be good for the economy: it lowered hurdle rates for businesses and encouraged capital-intensive expansions; it gave a boost to the housing industry and encouraged home ownership; and it increased purchasing power and encouraged consumer spending. But that was back in the dark ages, when debt was relatively more expensive than it is now. The financial world has changed a lot in the past 50 years, and debt is now far cheaper, far more easily available, far more efficiently hedged, and far more broadly (and deeply) traded than it was in the immediate postwar era. Its tax advantage might have been justifiable in the past, but it isn't anymore. We should get rid of it.

(We won't, of course, any more than we'll get rid of agricultural payments or road-building subsidies. If you scratch most free market capitalists you'll find a socialist just below the surface. But we can still dream.)

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Comments

Thank God the mortgage interest deduction is sacrosanct

Submitted by Dave Brown on Tue Jul. 14, 2009 10:15 AM PDT.

Thank God the mortgage interest deduction is sacrosanct. Removing one of the cornerstones of America's middle class would be an economic disaster. Construction is the largest nongovernmental sector of our economy, and home construction and remodeling is a significant proportion of that. Eliminating the deduction on mortgage interest would idle millions of workers.

Let's also be thankful that bloviators like Felix Salmon don't run our economy. Mr. Salmon obviously doesn't understand the challenges faced by our economy, and he naively assumes that in this day and age a change in the U.S. tax code can have worldwide effect.

Canada doesn't have the

Submitted by g. powell on Tue Jul. 14, 2009 10:32 AM PDT.

Canada doesn't have the mortgage interest deduction and they have a strong middle class. Housing prices would adjust to what consumers can afford. Less borrowing would also prevent debt-fueled bubbles from emerging.

Housing construction became an unsustainable large part of our economy. In the end it took resources away from where they could be more productively employed.

Recommend

Submitted by Art Eclectic on Wed Jul. 15, 2009 6:33 AM PDT.

I can't hit the recommend button enough. As much as it will hurt my own wallet, EVERYTHING that makes housing more "affordable" by propping up prices needs to go. What we need is not more ways for people to get into houses they can't afford, we need ways for the houses to become affordable without gimmicks and adding more debt onto the consumer.

Prices must drop to where the average middle class family can buy with 20% down and within 36% debt-income ratio. Anything else is just propping up inflated housing prices that only benefits realtors, mortgage brokers and builders.

Donor

What EXACTLY is wrong with debt?

Submitted by keithofrpi on Tue Jul. 14, 2009 10:17 AM PDT.

Kevin,
Why is debt bad? Much of the world's recent growth in wealth comes from a great increase in our ability to extend credit rationally--an ability based on the existence and liquidity of credit markets, the growth of computer-based modeling, advances in portfolio theory, etc.; in other words, advances in our knowledge. These advances have allowed us, much more than ever before, to use future earnings for present investment; that is, to increase the amount of debt. The benefits have been very great. Debt is not, itself, the problem; it is the use to which some fools have put some of their borrowing, and the excesses by those fools who extended credit inappropriately. These are problems which good regulation, especially improvements in the regulation of corporate governance, can largely fix.

Kevin didn't say debt is

Submitted by g. powell on Tue Jul. 14, 2009 10:35 AM PDT.

Kevin didn't say debt is bad, he said too much is bad. Debt of course can be used for productive purposes. Incentives to borrow too much causes investors to make bad decisions.

Debt is not wealth.

Submitted by Art Eclectic on Wed Jul. 15, 2009 6:35 AM PDT.

Debt is not wealth. Debt does not increase wealth except for those investing in it at the top of the financial food chain.

The U.S. already has the

Submitted by MacGruber on Tue Jul. 14, 2009 10:19 AM PDT.

The U.S. already has the second-highest corporate tax rate on the planet. Now, in the midst of a recession, liberals want businesses to pay more. No doubt in an effort to pay for more pork-laden stimulus programs that will do nothing to help the economy.

And leave it to liberals to voice approval in raising taxes on the middle class via the elimination of the mortgage interest deduction. And no, it won't happen because capitalists are really socialist; it won't happen because Obama promised that no one making under 250K will have their taxes - any type of taxes - raised under his watch.

These ridiculous proposals are fighting the last war; the free market has already tightened debt, as have individual households. There is no need to stiffle the economy through these draconian measures.

Unless you are looking for monies to pay for more liberal government spending programs.

This week's most annoying

Submitted by WHS (not verified) on Tue Jul. 14, 2009 10:20 AM PDT.

This week's most annoying trend in progressive blogs: arguing for a policy change and immediately pointing out, in a bitter little postscript, that it'll never happen. I swear I've seen it about three times already this afternoon. We all know that the government is broken and the Senate should be abolished, no need to rub it in our faces. Especially when legislative reform is also treated as a complete pipe dream.

Isn't it obvious that this

Submitted by g. powell on Tue Jul. 14, 2009 10:36 AM PDT.

Isn't it obvious that this country needs to make some basic structural changes if it is to avoid national decline. And isn't it obvious that entrenched interests are making this all but impossible. Is it bad taste to point this out.

It's not just government that's broken

Submitted by Chris Andersen (not verified) on Tue Jul. 14, 2009 12:13 PM PDT.

Take the example of eliminating the mortgage interest deduction. If you seriously suggested that the voters would rise up as one and burn you at the stake.

Don't blame Congress when they respond logically to how the voters act.

transitory advantages.

Submitted by BigTom (not verified) on Tue Jul. 14, 2009 11:03 AM PDT.

Clearly their are (were) transitory advantages for the economy whenever credit was made easier. On the margins and easing of credit increases spending (on either consumables or investment), and this has proved to be irresitable. Subsidies, such as tax breaks for mortgages, when introduced make housing more affordable, but arguably over time prices (of real estate) rise to consume the subsidy. Then taxes are made up in some other form. Economists refer to such subsidies, and market distortions. And they rarely make the economy work better, but once enacted they create an army of stakeholders who will fight tooth and nail to keep them. A few years back there was an attempt to fix taxes, by limiting the mortgage deduction, and using the freed funds for other needed breaks -such as eliminating the alternate minimum tax, and reducing tax rates. But, realestate interests killed it off.

Subsidizing Home Ownership

Submitted by Don the libertarian Democrat (not verified) on Tue Jul. 14, 2009 12:07 PM PDT.

The reason that we have govt subsidizing debt and using tax incentives is that we hate to give people money. That's it. Helping people buy a house makes sense, if you're trying to spread the wealth, and not have it concentrated in the hands of landlords. The simplest method would be to give the less well off the money for a 20% down payment. That makes economic sense. Of course, you've just obviously given someone money outright. Since we can't do this in the US, we have a complicated system that is inefficient and impossible to grade until it blows up.

The answer is to give people money if you want to help them. That's why I'm for a guaranteed income or housing subsidy of cash.

Interest Deductions

Submitted by oldhiker on Tue Jul. 14, 2009 1:16 PM PDT.

The main reason for a corporate interest deduction is that you want to tax a corporation on its net income and interest is a valid business expense category. A business borrows because the financial wizards calculate that the rate of return on investment of borrowed money exceeds the cost. Not allowing business interest deductions would only change this calculation slightly. And it might push the whole calculation towards moving the business out of the USA, which already has the highest corporate tax rates in the world.

As for the mortgage interest deduction, it is pointless. The government should not be encouraging home ownership. which, after all, is not risk free, as millions can attest. We should do like England, and phase it out over ten years or so.

Various Interest-related Topics

Submitted by Don K (not verified) on Tue Jul. 14, 2009 1:42 PM PDT.

Well, one could eliminate the mortgage-interest deduction (and I think it's one of the stupidest deductions on the 1040), but that would just lock even more people into their present residences, because the values of their homes would fall to below their mortgage balances. Over time, things would work out, but it would be a hell of a transition.

Similarly, one could eliminate tax-free municipal bonds, but that would just increase the borrowing rate for your favorite municipality (or state). That would be popular when the school district has to come around for an increase in the millage because of increased interest costs on the as-yet unissued construction bonds. And no, I don't think it would be fair to penalize the owners of existing bonds. They took lower-than-market interest rates in return for the tax-exempt status of the interest.

Finally, with regard to deductibility of corporate interest, is it a legitimate expense along with salaries, materials, energy costs, depreciation of capital goods, etc.? If so, then it should be deductible. If not, then get rid of it. I agree the difference in treatment of interest and dividends is stupid, and incents businesses to overlever. I'd go to the British/Irish system of allowing deduction of dividends (to the extent of previously taxed income). Sometimes I'm amazed the extent some liberals will go to retain their cherished double taxation of dividends.

This seems a little simplistic to me

Submitted by Ulysses Berman (not verified) on Tue Jul. 14, 2009 1:53 PM PDT.

As noted, debt isn't as much the problem as is the level of debt. Also, as noted, this would have significant impacts on both the housing market, as well as the consumer component of GDP (70%).

While far less trivial to implement and administer, going after leverage at both the individual and corporate level gets to the root of the problem

Also, Macgruber, just stop. If you don't understand the difference between nominal and effective rates, then you're spouting off without knowing wtf you're talking about. If you do understand the difference - and thus understand that the effective rates paid in the U.S. are much lower than the nominal rates - then you're flat out dishonest.

So either do your homework or stop lying.

(Sorry, I've just lost all ability to tolerate these people)

So, World = USA and Solution = US tax system

Submitted by The Lounsbury (not verified) on Tue Jul. 14, 2009 2:56 PM PDT.

If you mean the US, I might suggest, my dear provincial author of dubious financial literacy, that you write USA. Word, I have to say, even by the most abusive reading, is not as yet synonymous with USA. Is revealing though, what Leftists write unguarded.

How broken is it?

Submitted by MarkH on Tue Jul. 14, 2009 5:11 PM PDT.

If anything about the housing industry were so out of whack that it was strangling our economy, then I'd want to look at it. But, before the crash it wasn't a big problem, so I'm guessing it isn't now either.

However, anything which causes a huge drain of capital from banking or businesses or from consumers pockets without a compensating balance somewhere else ... that gets my attention.

For example, subsidies to oil & gas, ethanol producers, sugar producers and the like. They might be undermining our government's fiscal soundness, the country's economy, the environment or individual health. Those are problems.

Which needs most attention? Seeing as how our economy, and the world's, is in less-than-perfect shape, that's where my attention is drawn. So, tax credits for mortgages don't seem so important.

Similarly, wasteful fed. gov't spending has got to be a big no-no just now. I was very pleased to see Sen. McCain giving a speech today deriding the F-22 program. I think that's where we are and I applaud him for taking that position.

I also liked reading an article about Tim Geithner visiting the Arabian Gulf states and discussing their return to investing in America. We need sound capital, not just newly printed waste paper, and their money has been based on energy development (primarily), so it's not inflationary.

I also liked reading about ExxonMobil and Dow getting into the production of biofuels. Hurrah for them!

Those are potential sound solutions to our problems and I'm for that.