July 28, 2009 4:53PM

For Financial Stability, Fix the Tax Code

There seems to be near universal agreement that the excessive use of debt among both corporations, particularly banks, and households contributed to the severity of the financial crisis. However, other than the occasional refrain that banks should hold more capital, there has been little discussion over why corporations choose to be so highly leveraged in the first place. But then such a discussion might lead us to the all too obvious answer — the federal government, via the tax code, encourages, even heavily subsidizes corporate leverage.

Cato scholar and banking analyst Bert Ely has estimated that the subsides for debt have historically resulted in an after tax cost of debt of 3 to 5 percent, compared to an after tax cost of equity of 12 to 15 percent. With differences of this magnitude, it should not be surprising that financial companies and corporations in general become highly leveraged.

For corporations, this massive difference in cost between debt and equity financing results primary from the ability to deduct interest expenses on debt, while punishing equity due to the double‐​taxation of dividends along with taxing capital gains. 

If we are going to use the tax code to subsidize debt and tax equity, we shouldn’t act surprised when firms load up on the debt and reduce their use of equity — making financial crises all too frequent and severe.