While policymakers struggle with identifying and enacting the appropriate short-term policy response to the financial crisis and economic downturn of 2008, 2009, and perhaps beyond (henceforth "the crisis"), both academics and policymakers are examining the causes of the crisis and what lessons this might bring to bear on longer-term policy. With near unanimity, attention to both the causes and appropriate long-term policy response has focused on the financial sector, (1) although fiscal policy, including tax policy, has certainly figured prominently in countries' short-term policy responses to the economic contraction. In recent months, though, officials from two international organizations, the IMF and the OECD, (2) have produced reports addressing what aspects of the tax system may have helped cause or exacerbate the crisis, and whether tax policy needs to be re-evaluated in light of the recent events. That the public finance community participates in such a re-examination is appropriate; indeed, it is a professional responsibility. There is likely enough policy blame to be spread among many policy areas and, even if bad tax policy is not the (or even a) proximate cause of the crisis, our view of how the world works has fundamentally changed in ways that invite a thoughtful and perhaps humbling reassessment of what good tax policy looks like. In this article I do not, alas, offer such a fundamental reassessment of tax policy. Instead I offer some speculations about the lessons for tax policy, and the analysis of tax policy, from the Great Recession. What did we get wrong? What did we underestimate the importance of? What do we need to think more about? THE TAX PREFERENCE FOR CORPORATE DEBT FINANCING One obvious link between tax policy and the crisis is the tax preference for corporate debt finance. The U.S. income tax system, and that of most other countries, favors debt financing over equity financing because of the deductibility of interest payments and the non-deductibitity of the cost of equity capital. To some extent this may be offset by preferential individual tax treatment of the returns to equity investments, such as the enactment in the United States of capped rates of tax on dividends beginning in 2003, but offsetting this is the growing importance of effectively tax-exempt investors, for whom any investor-level tax preference for equity does not apply--overall, a net preference for debt finance almost certainly prevails. To the extent that leverage is thereby higher than otherwise, so also is the susceptibility of the corporate sector to bankruptcy. This link is no surprise to public finance economists, who have addressed this issue theoretically and tried to estimate by how much the tax system increases corporate leverage. Hindsight circa 2009 suggests that we might have underestimated the social costs of increased leverage. A literature in finance has focused on the real costs of bankruptcy, and struggled to find them to be large. (3) In retrospect, what was missing was an examination of the contagion effects, or externalities, of bankruptcies in an economic climate like the current one. The familiar story about the tax-related incentive to debt finance is worth another look. Note that it presumes that, in order to obtain the tax advantages of interest deductibility, corporations must change the risk profile of their obligations to the providers of capital. This may not be true, though, if a corporation can obtain the tax advantages without altering the character of its obligations. In principle this could be done by issuing hybrid instruments such as convertible debt obligations, which qualify as debt according to IRS rules, but which have equity-like characteristics. (4) As Shaviro (2009) emphasizes, divorcing the tax treatment from the true underlying financing characteristics effectively allows investors to elect whether they wish to be taxed at the corporate tax rate (through equity finance) or their own individual marginal tax rate (through debt finance). Especially in the presence of heterogeneous individual marginal tax rates, the social cost then comes in the form of lost revenue rather than a distorted corporate risk profile and in that event is unlikely to have played a direct role in precipitating or exacerbating the crisis.
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