Could Tax Reform Help Make the Financial System Safer? by Simon Johnson

[Jefferson23]

My written testimony to the joint hearing of the House Ways and Means Committee with the Senate Finance Committee is here.

In the deafening cacophony of Washington-based voices on the debt ceiling, it is easy to miss a potentially more significant development. There is growing bipartisan interest in tax reform, including changing the corporate tax system to make it more sensible – and a bulwark against financial sector instability.

The House Ways and Means Committee and Senate Finance Committee held a joint hearing last week – apparently the first time these two committees have met in this fashion to discuss tax in over 70 years. The theme of the hearing might sound a little dry, “Tax Reform and the Tax Treatment of Debt and Equity,” but in fact it was well-designed to carve out some space for future agreement across the political spectrum.

The basic premise of the hearing was the question: Did the tax code contribute to the severity of the financial crisis in 2008-09? At one level the answer is simple: Yes, because the tax deductibility of interest payments encourages families to take out bigger mortgages and companies to borrow more relative to their equity capital (as dividend payments to stock owners are not tax deductible). But where within the tax code should we focus attention, if the goal is preventing similar crises in the future?

I testified at the hearing – my testimony is here – and I argued that banks and other financial institutions should be the priority, because their overborrowing was central to past crises and is likely to be a salient issue in the future. It is also ironic – or perhaps even bizarre – that while we try to constrain how much banks borrow through regulation, we also give them strong incentives to borrow more through the tax code.

in full: http://baselinescenario.com/2011/07/23/could-tax-reform-help-make-the-financial-system-safer/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+BaselineScenario+%28The+Baseline+Scenario%29