One Reason We Tend To Go Bubble and Bust Around Here

February 22nd, 2012 at 3:31 pm

No wonder we tend to get a tad overleveraged in this country. 

The figure below, from data in the new White House/Treasury corporate tax framework, shows the effective tax rates on new investments as a function of whether the investment is financed through debt (borrowing) or equity (issuing stock).  

Source: White House, Treasury Dept.

This looks awfully like one of them there distortions in the code we’d want to go after in the context of tax reform.  As per the report, the WH and Treas are thinking along these lines:

Reducing the bias toward debt financing. A lower corporate tax rate by itself would automatically reduce but not eliminate the bias toward debt financing. Additional steps like reducing the deductibility of interest for corporations should be considered as part of a reform plan. This is because a tax system that is more neutral towards debt and equity will reduce incentives to overleverage and produce more stable business finances, especially in times of economic stress. In addition, reducing the deductibility of interest for corporations could finance lower tax rates and do more to encourage investment in the United States than keeping rates higher or paying for the rate reductions in other ways.

It’s a good idea, and as I continue to stress, a test of how sincere the lower-the-rates-broaden-the-base crowd are re the second part of that mantra.

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7 comments in reply to "One Reason We Tend To Go Bubble and Bust Around Here"

  1. Blake says:

    They are entirely unserious about the “broaden the base”. After a discussion with a WH official and a Cato bobble head, Brian Sullivan, the host at the time on CNBC asserted with a straight face. “I’m not making a political argument, but if you take away a deduction, you are raising taxes”. Hardly surprising on a network whose anchors are nearly always engaged as Republican partisans.

  2. Fred Donaldson says:

    while one of the recipients (victim) of two investment firm takeovers of where I worked, we were painfully aware that their only success at the highest level meant more takeovers, more debt, more cuts, more profits even despite those same cuts.

    The final straw came when nearly all profits went to servicing the debt, which finally left nothing to use for more acquisitions and phoney sinergy or improve existing products.

    Most companies realize there is an “institutional” power – even if you reduce services or products, sales continue strongly for some time after the cuts.

    Finally, it caught up with us, and we were publishing newspapers, and the company went bankrupt. The NYSE top CEO and others did very well. The workers saw more cuts under dreaded reorganization, and some college-trained folks were making less than $8 an hour.

    A tax code that promotes debt versus equity leads to the destruction of firms in favor of quick profits and long term destruction of businesses.

    As the CEO of a division, it was heart-breaking to see jobs lost, people’s lives destroyed and great institutions raped for the glory and greed of a few.

  3. David says:

    As Lester Thurow observed three decades ago in The Zero Sum Society, another effective way to reduce the bias is to eliminate the corporate income tax entirely and tax all income back to shareholders as in an S corporation. That is, we tax you on your share of net income whether you’ve received a dividend from your holding or not. Either way, there’s no more double-taxation, which is one of the forces that drives corporations toward more tax-efficient debt financing. Is this reform likely? Probably not. But definitely breaks the bias, no?

  4. Bud Meyers says:

    Off topic but…

    Judging by your past posts, I figured you liked charts, so I thought you’d be interested in this article.

    I was searching for historical data for U.S. oil exports, consumption, prices, and production – – and found this article (which also includes 30 charts) about oil from 1868 to the present:

    But it’s over my head and I was wondering if someone like yourself could write a brief and less comprehensive (but more comprehensible) synopsis on this article.

    The very long-term data and the post World War II data suggests a “normal” price far below the current price for a barrel of oil. However, the rise of OPEC, which replaced the Texas Railroad Commission as the monitor of spare production capacity, together with increased interest in oil futures as an asset class, introduced changes that support prices far higher than the historical “norm.”

    It appears that speculation (by those who never actually take delivery) in oil futures is the biggest driving force of oil prices. Goldman Sach’s alone has huge blocks of stock in oil companies and trades vast quantities of oil futures.

    Domestic production under Obama has risen (even with the moratoriums) and domestic consumption is down, and supplies have not been disrupted, but prices are still going higher…even before discussions of the Keystone pipeline and Iran’s threats to close the strait (which our military could still keep open if that was ever attempted).

    If the Keystone pipeline only adds to the “world supply” at “market prices” that can be sold to other countries, how can it help domestic prices and supply, and give the U.S. “energy independence” (or for that matter, besides just oil, any other energy “asset”, including bio-fuels)?

    While I understand that many average Americans benefit from profits made in the oil industry, like day traders, or if our 401ks, pensions, or Roth IRAs are invested in oil companies, when WE withdrawal our funds, we’re taxed as ordinary income. That’s why I wrote my post “Keystone Pipeline: It’s WE who should get into the oil business!”

    On topic…

    Obama Tax Plan vs. Mitt Romney’s

  5. wkj says:

    It would reinforce your point to show the effective tax rate on a leveraged purchase of a personal residence where the gain is tax-exempt up to $500K.

  6. Michael says:

    I’m not a big fan of corporate tax rates; it seems to me that we’d be well served by just cranking up the marginal rate on wealthy taxpayers by taxing investment and wage income equally.

    Really, this is a side issue. The problem is lack of prosecutions for felonies and the impossibility of getting a corporate charter revoked. Compared to that, this is nothing.

  7. jonathan says:

    This point hits directly at Romney. His firm made money by buying companies that had cash flow and then loading up with debt to and beyond the limits of that cash flow, taking out as cash as much as possible from the borrowing, and then cutting costs to generate enough cash flow for the business to continue. This meant the taxpayer paid a huge portion of his gains.