The Debt Economy

In the 11/23/2009 New Yorker James Surowiecki points out that "the government helped pay for the debt binge that created the mess in the first place, thanks to a tax system that actually subsidizes borrowing."

His point is, I think, to argue that there is a "debt bias" in the tax code, and that the debt bias - among other things - creates an illusory social benefit. For example, with respect to "tax shield" provided by home mortgage interest deductions, seller's know a buyer's ability to buy is extended by the tax benefits they can claim, and so they tax a bite out of the shield by increasing their sales prices. The deduction "simply inflates house prices."

That's good as far as it goes.

But isn't it a little contradictory to say there is a debt bias? If the market drives away the advantages the tax code puts on debt, shouldn't there be some point at which the advantage is priced out of the market, and the decision to buy or rent equalized. Similarly, isn't there a point at which the value of a corporate tax break for interest deductions is offset by a lower dividend tax rate that might prefer to raise lots of amounts of capital through shareholder contributions over incurring obligations of debt? In other words, doesn't the market price out bias?

That's not to say there wasn't a distortion created by a tax break, but that's not the same as saying the market priced the distortion away. In fact, there is a body of thought that simply says the tax gimmicry that tends to favor one decision (like to take on debt) over another (life to raise capital) only works for a time. That's the reason why economists say the effects of tax breaks are temporary. If you really think about it, tax breaks get compounded into the market fairly quickly. For example, when President Clinton enacted the 2001 tax relief - and allowed a $250,000 exclusion from capital gains on the sale of a principal residence - the probable effect was to raise the price of homes. This was a good thing for sellers at the time. Later sellers simply bought and sold homes that were inflated by the value of the break. The net effect of the break to them would have been zilch.

It's not at all clear to me why a debt bias, as it is, "means the over-all tax rate is higher." Is this to suggest that corporate tax rates must be raised to counter the effect of the tax break for debt? I'm not sure that's the case. That maybe ignores the other preferences built into the code: the loss of corporate tax through use of limited liability companies taxed as partnerships, REITs, S-Corporations, business trusts and the like. Whatever he may say, corporate tax rates have stayed remarkably stable since about 1988 (after dropping from a top marginal rate of 46% in 1988).

Also, claiming there is a debt bias ignores the various preferences for capital gains (especially the preferences that drive capital investments chasing lower gains rates) and - particular to the residential market - their effect on homebuilding. Mr. Surowiecki is right to say debt drives economically inefficient home purchases, and other inefficiencies, but only partly so. Low capital gains rates play a pretty big role here too.

If that's the case, there is a much bigger problem here than his article suggests. The fix is not simply to eliminate debt bias. If taking the mortgage interest deduction away is impalpable, consider combining that with eliminate capital gains rates, taking away the residence exclusion, eliminate the deduction for state and local taxes. I suggest the author's fix would not be a fix, and that a real fix isn't something we are ready for. Or something we're much used to doing at all.