Monday, July 25, 2011

Tax Codes (Yawn!) for Financial Stability?

No one (I hope) enjoys reading about tax codes, but Simon Johnson makes a very good point: they make be potentially very useful in helping to stablize markets.

His reasoning is simple. Any number of studies show that, other things being equal, the use of more leverage by banks, hedge funds and other investors creates more instability -- it can amplify small market fluctuations into far larger market upheavals. So stability would be improved by limiting leverage (although how much to limit it is a matter of some subtlety). You can limit leverage with laws, or with incentives. Johnson is thinking about incentives, particularly through the tax code (in the US). Currently, if a hedge fund seeks leverage by borrowing money, they pay interest on that loan and that interest can be deducted from their taxes. Interest payments are deductible. In contrast, if the same fund raises money by selling shares of its stock, they pay dividends on those shares. Those dividend payments are NOT deductible in US tax law. Hence, investing firms have every incentive to raise money for leverage by borrowing, rather than by selling stock.

An elimination of this tax difference may be one way to attempt to reign in the use of leverage and keep it within the bounds of safety. For those interested in the gritty details, see Johnson's testimony at a recent meeting on (double Yawn!) Tax Reform and the Tax Treatment of Debt and Equity.