Policymakers in Washington appear to be coming together for a compromise on the fiscal cliff. While the proposed changes may do something to help the government’s budget deficit and debt situation, tax policies still distort incentives and put the economy at risk.
When negotiating over tax and spending policy at both the state and national level, policymakers should remember the basic economic principle that people respond to incentives. Everyone in society loses when the tax code alters incentives and distorts the allocation of resources.
Even if a fiscal-cliff compromise raises more revenue and reduces long-term spending, the way the government is raising revenue creates too much risk. Our tax structure encourages households and corporations to use debt over equity when making investments.
Income taxes, both corporate and individual, are lower when individuals pay more of their return on an investment to those who hold a mortgage or other debt liens against the project. The housing bubble and financial crisis should have been a lesson in this risk. But nothing has been changed to remove the incentives homeowners now have to borrow more than they can afford.
Further, because interest income paid to a debt holder is taxed, the current state and federal tax laws discourage saving. When someone does save to make a big purchase, like a house, he or she pays a “penalty” on these savings in the form of taxes on the interest earned.
For corporations, whose tax rates are higher than most individuals pay, the distorted incentives are even worse. The U.S. corporate tax rate is the highest among developed countries, and corporations have no incentive to reduce risk by lowering debt.
At 7.6 percent, Idaho has one of the highest corporate tax rates in the country. Corporations operating in Idaho can lower their overall taxes by adding more debt.
According to the Federal Reserve, corporate debt is growing at an annual rate of 6.9 percent. In the past two years, U.S. corporations added nearly $1 trillion in debt to their books at a time when the economy was doing poorly.
As is painfully clear today, government debt is also growing fast. The economy is growing at just over 1 percent a year, but federal government debt is rising at nearly 11 percent. While state and local debt declined in 2011, it has risen by more than $250 billion in the past five years.
Tax incentives are at work here, too. The current tax rules explain why so many investors want to help the government finance its deficits.
A holder of a U.S. Treasury bond pays no state income tax on the interest earned. There is a strong incentive for investors, particularly those in states with high personal income taxes, to keep their savings in government debt.
These same investors can earn a double tax benefit when they buy the bonds of their local and state governments. Municipal bonds are generally free from state and federal income taxes.
This incentive drives wealthy investors away from private investments and toward the government. An investor in Idaho, for example, who pays a 35 percent federal tax rate and a 5 percent state tax rate is earning the equivalent of 6 percent on a local municipal bond paying just 3.6 percent.
People respond to incentives, and the incentives of our tax code are supporting bad habits.
The U.S. economy has been on a borrowing binge for decades now. Policymakers may want to argue over tax rates, but broader reform is needed to break our addictions to debt.
Peter Crabb, professor of finance and economics at Northwest Nazarene University in Nampa. firstname.lastname@example.org