IMFSurvey Magazine: IMF Research
GLOBAL FINANCIAL CRISIS
Tax Policies Made Countries More Vulnerable to Crisis
June 16, 2009
- Tax policies favored debt rather than equity finance and led to higher leverage
- Tax distortions encouraged development of complex financial arrangements
- Tax reforms to address long-standing distortions are needed once global economic crisis has passed
Tax policies in the advanced economies are likely to have contributed to the global economic crisis by favoring debt financing and encouraging the use of complex financial instruments and arrangements, an IMF study argues.
IMF economists examined the role played by tax policy in corporate finance, housing, complex financial arrangements, the use of low-tax jurisdictions and tax havens, risk taking, and the development of asset prices—all of which can have effects on the larger macroeconomy.
The study, titled “Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy,” discussed at the IMF Executive Board, draws a number of conclusions from a spectrum of country policies and practices.
Debt finance favored
Corporate-level tax biases favoring debt finance, including in the financial sector, are pervasive and often large. By allowing interest payments as a deduction against corporate income tax, but not the cost of equity finance, tax policy has a potential impact on financial stability by leading to higher levels of leverage in the financial system.
Given the large damage from excess leverage, including through effects on the balance of payments, the study considers a range of possible remedies. One would be by allowing a deduction not only for interest on debt but for a notional return on equity. Some countries, including Brazil, Italy, Austria, Belgium, and Croatia, have adopted this approach (or variants), with results that are widely seen as positive.
Mortgage Tax Breaks
Mortgage interest relief for owner occupied housing, in countries which still retain this deduction, may well have encouraged heavy household leverage, though tax policy was not the main driver behind housing price bubbles over the past decade.
The IMF said in the short term, creating more tax breaks for housing should be avoided and, when housing markets recover, long-advocated reforms such as phasing out mortgage interest tax relief—which experience shows can be done without undue difficulty—will need serious attention.
Role of securitization and other financial innovation
The development of complex financial instruments has been encouraged by a search for ways to avoid taxes. Instruments like swaps and deep discount securities, for instance, can be used solely for that purpose. Tax policy in some cases facilitated securitization, but there is no evidence that it drove its widespread use in the lead up to the crash of the housing market, the IMF paper said. Much remains to be learnt in this area, including on the circumstances in which tax-driven innovation reduces the cost of underlying tax distortions and when, to the contrary, it amplifies underlying difficulties.
While the salaries and stock option compensation of CEOs have garnered much attention in the wake of the economic crisis, the IMF study found that tax policy has not systematically favored the use of stock options. Country practice varies widely, however, and other tax rules in the United States, for instance, are likely to have encouraged widespread use of performance-related pay.
Tax policy has been used to affect asset prices in many countries. The study emphasizes, however, that these effects can be complex and hard to predict. The paper concludes that regulatory measures will often be a better way to deal with unwelcome asset price developments.
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