The tax break that broke Wall Street

Understanding that the tax code encouraged banks to pile up debt is not hard. Fixing it is a different story

Published February 8, 2010 7:45PM (EST)

At Capital Gains and Games, Pete Davis argues that the tax code helped precipitate the financial crisis. Specifically, the corporate income tax deduction available for interest that accrues on debt encouraged companies to borrow money for their acquisitions and trading bets, instead of investing directly in equity.

It makes sense. If you can write off the interest payments on debt as a tax deduction, but have to pay taxes on the income generated by actual ownership of equity, you will be steered toward debt by the not-so-invisible hand of the tax code. Davis writes that "the corporate income tax deduction for interest produced a -6.4 percent tax rate on debt financed investments, while the double taxation of equity income (dividends and capital gains) produced a 36.1% tax on equity financed investments."

So Wall Street went mad for debt-financed investments. We all know how that turned out.

James Surowiecki wrote an excellent piece on the problem for The New Yorker last November, pointing out that previous proposals to eliminate the corporate interest deduction have gone nowhere, but suggesting that "we're in a different historical moment now: the perils of too much borrowing have never been clearer."

Surowiecki's implication is that maybe now, as we survey the wreckage, we have the freedom to make some reforms. But Pete Davis is less hopeful:

The hard part of tax reform is that you have to raise taxes on those getting the subsidies. There are far fewer of them than the many taxpayers who stand to get slightly lower tax rates, so Wall Street corporations will finance the lobbying to kill tax reform before it has to chance to prevent the next financial crisis. We'll end up with watered down quick fixes at best, and the roots of the next financial crisis will remain in the Tax Code.

The last two paragraphs encapsulate a theme that appears in nearly every consideration of the possibility of meaningful financial regulatory reform today. We are in a different historical moment. The pro-deregulation ideological consensus that reigned supreme for the last 30 years has been broken.

And yet this difference makes no difference. The Wall Street banking lobby seems just as powerful in Washington as it was before the crisis. Even worse -- after the Supreme Court ruling earlier this year throwing out restrictions on political spending by corporations, it may even be more powerful.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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