Did Taxes Cause the Financial Crisis?

August 28, 2013

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, says Mark Roe, a professor at Harvard Law School.

  • Financial firms in the United States pay about 34 percent 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.

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 clearly tied to the explosion in risky mortgage-backed securities in the United States.
  • 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.

All of this is true, but, given the possibility of a major overhaul of U.S. 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, it may be the case that 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.

Source: Mark Roe, "Did Taxes Cause the Financial Crisis?" Project Syndicate, August 21, 2013.

 

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