The team at Our Fiscal Security, a collaboration between Demos, the Economic Policy Institute, and The Century Foundation, have just put out Investing in America’s Economy: A Budget Blueprint for Economic Recovery and Fiscal Responsibility (PDF here). I'm sure the blogosphere will be kicking the plan's tires over the next weeks.
For those who think of financial reform as an incomplete project, there are four things of interest in their budget proposal that act as de facto reform:
This proposal would also replace the mortgage interest deduction with a fully refundable tax credit. Under current law, homeowners can deduct interest payments on up to $1 million in mortgage debt and up to an additional $100,000 in other loans, such as home equity loans, regardless of their use. Value of this benefit goes disproportionately to upper-income homeowners because of the greater value of their mortgages and because they receive a larger benefit per dollar of mortgage debt.
Making the deduction a refundable credit would increase the value of the credit for many homeowners. The deductibility of mortgage interest on owner occupied homes is projected to cost $149.6 billion in 2015, or $637.6 billion over 2011-15. We propose converting the deduction to a refundable tax credit of 15% of interest on up to $500,000 in mortgage debt, which in itself would save $51.6 billion in 2014 and $387.6 billion over 2010-19.
It shouldn't surprise us that a credit bubble inflated our housing market, given the subsidies we have for housing. If you are a fan of housing policy, you should also be a fan of homeownership, not home buyership or home indebtedness. And this subsidy creates incentives for consumers to become indebted. This subsidy also is ineffective and highly regressive, and as such should be abandoned. The proposal gets us part of the way there.
Limit the deductibility of corporate debt interest payments for financial firms
When planning investment strategies, corporations take advantage of a tax preference that encourages debt-financed projects over projects financed by other means. Interest payments on corporate debt are counted as a business expense and are thus paid from pre-tax income. Requiring that interest payments be made from after-tax income, as dividend payments and stock repurchases are made, would encourage corporate financing using retained earnings or new equity. While there are many legitimate reasons for firms to take on debt, limiting the so-called “debt tax shield” for financial firms would generate significant revenues and discourage destabilizing high ratios of financial leverage, which have proven to impose significant economy-wide costs.
We propose limiting the tax preference for corporate debt interest payments for financial firms to 25%, below the top corporate tax rate of 35%, by making the preference an after-tax credit of 25% rather than a pre-tax expense. We estimate that limiting the tax preference to 25% of interest payments would generate $77.1 billion by 2015. Less revenue would be collected if there were a large reduction in borrowing resulting from this policy, but the policy objective of decreasing systemic financial risk would be furthered and capital would be freed up for more productive, less speculative investment. This proposal gives policy makers significant scope to adjust the parameters. Extending the 25% proposed limitation of the tax preference on interest payments to nonfinancial corporations, for example, would generate additional revenue of $38.0 billion in 2015. This variant of the proposal would help to level the playing field between firms that rely on equity financing and firms reliant on debt financing, but taxing nonfinancial sector debt would not come with the added bene#t of dampening speculation and reining in systemic financial risks.
This is a game-changer. A comment I've often heard is that if reformers are so worried about leverage in the system, why encourage it with the tax code? We would need less regulators to watch leverage if there is less of it, and there is more debt than there should be because interest on leverage is shielded from taxes. Mark Calabria of Cato has written about this ("Nor has there been any discussion in Congress about removing the tax preferences for debt. Washington subsidizes debt, taxes equity, and then acts surprised when everyone becomes extremely leveraged."), and so have Felix Salmon and Steve Randy Waldman ("Debt financing externalizes the risks of business activity and magnifies social costs, while equity financing concentrates risk among stockholders who signed up to bear it. Yet under current rules, taxpayers literally pay firms to get rid of stockholders and take on ever more debt."). It's great to see it introduced as part of the discussion, and I hope people worried about leverage in the financial and non-financial system see this as a way of reducing these risks.
Financial crisis responsibility fee
We recommend adopting the president’s proposal to impose a “financial crisis responsibility fee” designed to recoup taxpayer losses associated with the Troubled Asset Relief Program (TARP), which primarily benefited major financial institutions. The fee would apply only to financial institutions with over $50 billion in assets (estimated at roughly 60 institutions) and would be equal to 15 basis points (0.15%) of a financial institution’s covered liabilities. The fee proposed in the president’s budget is projected to raise $9 billion in 2015 and $90 billion over 2011-20, and it will continue until all of the costs associated with TARP are repaid. The Congressional Budget Office estimates that the fee would have a negligible effect on economic growth.
I discussed this Responsibility Fee when it was first proposed back here. A chart I created:
(That’s data from ffiec on total asset size for the top 50 bank holding companies, and Wikipedia’s participants amounts in TARP.) Taking the log of both sides, a 10% increase in bank size is associated with a 10.5% increase in TARP money received.
I was a big fan of prefunding the resolution fund for the largest firms. This didn't tax financial activity, but instead it taxed a certain type of financial institution -- the ones that were troublesome to resolve and/or push through bankruptcy in the past. This would ensure that only firms that genuinely benefited from ballooning would do so. A more aggressive approach to this part of the government budget would put this into action.
Financial speculation tax
While a financial transactions tax would not eliminate speculation or necessarily stave off financial crises, instituting disincentives to short-term speculating would be a step toward building a more resilient financial sector. The tax could generate revenue to fund investments to strengthen the economy in the wake of the financial-crisis-induced recession.
In 2004, the Congressional Research Service estimated that a 0.5% tax on stock transactions would raise roughly $65.6 billion a year, assuming no reduction in trading volume (Shvedov 2004). Adjusting for nominal GDP growth and assuming a 25% reduction in transactions, we estimate that a financial transactions tax would raise $77.4 billion by 2015. Expanding the tax to derivative financial products would generate significantly more revenue... The United States used to have a financial transactions tax, and many advanced economies, including Great Britain, collect revenue from financial transactions without any noticeable harm to economic performance. This policy would complement the financial crisis responsibility fee, discussed above, and revenue from the tax could be used to invest in jumpstarting the broader economy.
Until this report, nobody has put a financial transaction tax on the table. Some have argued that the explosion in derivatives is simply a capital structure arbitrage for bankruptcy formalized in the 2005 bankruptcy bill. A slight tax could make sure that banks could only replace a supply order with a "swap" to confuse capital structures if it added real economic value. There are many ways, both on the drawing board and implemented across many countries, to structure this financial transaction tax.
It's good to see financial reform, a crucial piece of our government that is still a work of progress, bolstered by a strong liberal vision of our priorities as put into action by a budget plan.
Mike Konczal is a Fellow at the Roosevelt Institute.