U.S. tax policy is extremely foolish on several counts. One of the most important, it now appears, is creating perverse financial incentives and thereby contributing to last year’s economic crisis.
The International Monetary Fund has completed a study of the U.S. economy and crash. Reports former Reagan Treasury official Bruce Bartlett:
The most important problem identified by the IMF is the favorable tax treatment of debt and the punitive taxation of corporate equity in our system. This problem is exacerbated by a higher corporate tax rate in the U.S. than exists in most other countries, which magnifies the benefits of debt relative to equity.
The basic problem is that corporate profits are taxed twice: first by the corporate income tax and then again by the personal income tax when net profits are paid out to the corporation’s owners, the shareholders. As a consequence, the total tax rate on corporate profits is very high.
At the margin, profits earned by a corporation face a tax as high as 44.75%: 35% at the corporate level and another 15% at the individual level on the paid-out profits. But the maximum rate of 15% on individuals is only temporary and will expire at the end of next year. When that happens, dividends may be taxed as high as 39.6%, raising the combined tax on corporate profits to 60.74%. (The current top rate of 35% on individual incomes also expires next year.)
The Obama administration has proposed capping the tax on dividends at 20%, but this measure is not yet in law and may end up being sacrificed to pay for health reform or deficit reduction. The maximum tax rate on corporate profits would rise to 48% if it is enacted.
Some economists would say that the true rate is even higher because the capital gains tax is another layer of taxation. If we assume that the value of a share of stock is just the capitalized value of the future flow of dividends, then a stock price rise mainly results from a belief by investors that future dividends will be higher. Since those dividends will be taxed twice, one can argue that the capital gains tax is really a third tax on the same profits.
By contrast, debt is much more lightly taxed because interest payments are fully deductible against the corporate income tax. Moreover, purchasers of corporate debt are often tax-exempt entities such as pension funds, charitable institutions and sovereign wealth funds.
The result is that while corporate equity is heavily taxed, the tax system provides an effective subsidy for debt-financed investments. According to the study, the average effective tax rate on equity is 24%, but the rate on debt is -46%.
This wide spread led to the creation of exotic financial instruments designed to capture the tax benefits of debt while retaining the ownership rights of equity. These hybrid instruments are necessarily highly complex, making it hard for investors to judge their value and credit-worthiness. Thus, tax considerations helped fuel the growth of debt and the creation of difficult-to-price assets that are at the heart of the economic crisis.
There’s more to the economic crash, obviously, but this is just further evidence of the need for systematic tax reform and relief. We need to reduce and symplify taxes. Alas, that isn’t likely, to put it mildly. to be on the agenda over the next four years.