POSSIBLE POLICY RESPONSES - Taxation and the Financial Crisis

Practice varies widely, but major tax biases to the form of executive remuner-ation do not appear to have been endemic. Some country-speciﬁc action may be needed simply to achieve greater neutrality—for instance, removing caps on deductibility limits on ordinary salary (dealing with any equity concerns through progressivity of the general income tax). If it were felt necessary to go further and actively discourage the use of stock options—and a tax argument might be made that they reinforce the tendency to excess risk taking implied by limited liability (and implicit government guarantees)—such measures as denial of CIT deductibility (perhaps above some threshold) could be considered.

The carried interest issue turns on the fundamental distortion introduced by taxing capital gains and dividend distributions differently from labour income—which almost all tax systems are likely to retain. The fairness con-cern is a real one, but no fully satisfactory solution has yet been found.

2.5 Taxation andﬁnancial asset prices

Asset prices reflect expected future returns, and hence expected future tax payments. Recognizing this, tax policy can be used, and has been, to affect asset prices. The expectation that future capital gains will be taxed, for exam-ple, can in principle make bubbles less likely. Several countries indeed used tax measures to this end during the housing boom: the Republic of Korea, for instance, introduced in 2005 a national-level property tax charged at progres-sive rates on the combined value of all housing and land over a threshold value (with an exemption for one-person households), and from 2007 rein-forced a progressive CGT structure for housing. Ireland introduced an anti-speculative yearly ownership tax of 2 per cent of the market value of homes other than primary residences. In other cases, tax measures have been used, at least in part, to support asset prices. One benefit some anticipated from the 2003 dividend tax cut in the USA, for example, was a substantial increase in equity prices and consequent wealth effects. And in the present crisis, a number of countries have used tax measures to bolster house prices: Ireland, for example, removed stamp duty onfirst-time buyers (of relatively inexpen-sive properties) and extended mortgage interest relief.

Such asset price effects can be substantial. Poterba (2004) estimates, for example, that the 2003 cuts in dividend taxation and CGT in the USA increased share prices by around 6 per cent; ex post, Amromin et al. (2006)

ﬁnd the aggregate effect to have been muted, but with a substantial impact for high-dividend-paying ﬁrms. And there is evidence that announcements of reductions in stamp duty on share transactions in the UK have led to greater price increases for more frequently traded stocks.⁵³

Tax effects on asset prices, however, can be complex and hard to predict.

Three aspects of price behaviour are potentially important: level, rate of increase, and volatility. Tax measures can affect all three, and in ways that may be difﬁcult to anticipate:

A higher rate of CGT may cause the price of an asset to fall but its rate of appreciation to increase (in order to continue yielding the after-tax return available on other assets; see Box 2.2 for details). It is even possible for a higher CGT rate to be associated with higher asset prices (because any capital loss attracts a larger tax break).

Reducing dividend taxes may have no effect on equity prices if the marginal shareholder is non-resident (and so not subject to the tax).

Preferential tax treatment of the return on some asset can increase the volatility of its price (implying a relatively high variance of returns, as discussed in Section 2.3.3 above).

Transaction taxes, sometimes recommended as a way to decrease price volatility, have been found in some cases actually to increase it (by thinning the market).⁵⁴

Ad hoc tax policy measures are unlikely to be the best way to deal with unwelcome asset price developments. Compounding the uncertainties of effect just noted is the risk of creating unintended distortions and avoidance opportunities: for instance, lowering CGT in the attempt to support asset prices can create an incentive to transform interest income into capital gains. Gaps between announcement and implementation (or even the expec-tation of tax changes) can distort financial decisions (the anticipation of a reduction in stamp duty in the UK during 2008, for example, was reported to have led to some delaying of transactions). And lags in the adoption of tax changes can cause unwelcome pro-cyclical effects: tax increases on land hold-ings intended to quell the bubble in Japan, for instance, did not come into effect until after it had burst (Morinobu 2006). Tax measures can be attractive for their asset specificity and, in some circumstances, relative speediness. But they are no substitute for counter-cyclical policies, both monetary and poten-tially fiscal (applied across a range of instruments and maintaining tax

53See Bond et al. (2005), who examine the effects on share prices of reductions in stamp duty announced in 1984, 1986, and (though ultimately not implemented) 1990.

54See, e.g., Westerholm (2003).

neutrality properties). These would properly operate in part through effects on asset prices. Targeted regulatory actions are surer and better-focused instru-ments for dealing with particular assets, with structural tax policy best guided by the core objective of neutrality across assets and over time.

2.6 Conclusions

Tax distortions are likely to have encouraged excessive leveraging and other financial market problems evident in the crisis. These effects have been little explored, but are potentially powerful enough to have effects of macroeconomic significance. Taxation can result, for example, in a net subsidy to borrowing of hundreds of basis points, raising debt–equity ratios and vulnerabilities from capital inflows.

Box 2.2. TAXATION AND ASSET PRICES

In a world of perfect certainty, the price of a share-likeﬁnancial asset would evolve according to the arbitrage condition

rVt¼ ð1 TDÞDtþ ð1 TGÞ Vt ð1:1Þ where Vtdenotes the price of the asset of interest at time t, r the (ﬁxed and unchanging) after-tax return on some alternative asset, D the dividend, taxed at rate T_D, and T_Gthe (accrual-equivalent) CGT rate. (There are new equity issues, for simplicity.)

That a higher CGT rate may lead to faster price appreciation can be seen by taking the special case in (2.1) in which the current dividend is zero: the proportional price increase is then V=V ¼ r=ð1 TGÞ.

Solving (1.1), with limiting condition lim

t!1D_texpðrt=ð1 TGÞ ¼ 0, gives the asset price as:

V₀¼ 1 TD

1 TG

Z¹

D_texpðrt=ð1 TGÞÞdt ð1:2Þ

An increase in the dividend tax rate thus clearly lowers the asset price. The effect of a higher CGT rate, however, is ambiguous. On the one hand, it reduces the present value of future dividends because of the additional tax payable as the asset price rises to reﬂect them; it also, however, cushions the present value cost of any future reduction in the asset price. Differentiating in (1.2), the balance between these two effects can be seen to depend on the duration of the asset (that is, on the average length of time until dividends are received): a higher CGT rate reduces the current asset price if and only if duration is sufﬁciently long. The likelihood of a higher CGT rate leading, counter-intuitively, to increasing asset prices may be less in practice than this algebra suggests, however, both because opportunities for loss offset may be limited and because the taxation on realization rather than accrual provides an opportunity for asset-holders to lessen the price impact.

This chapter has reviewed the main channels by which tax distortions can signiﬁcantly affect ﬁnancial markets, drawing implications for tax design once the crisis has passed. Tax rules vary widely across countries, but some general conclusions emerge:

Corporate-level tax biases favouring debt finance, including in the financial sector, are pervasive, often large—and are hard to justify given the potential impact onfinancial stability. There is a strong case for dealing more decisively with this bias; for example, by also allowing a deduction of an imputed equity cost (which for regulatedfinancial institutions would be akin to an allowance for Tier 1 capital).

Continued favourable treatment of housing in many countries has supported high housing prices, while mortgage interest relief—where it remains—may have encouraged heavy household leverage. The risks in distorting a market so central toﬁnancial stability reinforce long-standing efﬁciency and equity arguments for more neutral taxation.

The development and use of complex financial instruments is generally driven by non-tax considerations, but is in part a response to, and shaped by, underlying tax distortions (such as relatively favourable treatment of capital gains, and cross-country tax differentials). Moreover, securitiza-tion and other devices can amplify the economic costs of those tax distortions (for example, by reducing the cost of subprimefinancing), and their use to secure favourable tax treatment contributes to opaque financial arrangements. Solutions are not simple, given the profundity of the underlying tax distortions.

Divergences in national tax rates, bases, and practices create substantial opportunities for international tax arbitrage, further increasing opacity and reinforcing tax biases to debt. Progress on‘tax havens’ addresses issues of evasion but not fundamental ones of tax avoidance. Measures to address the latter that are both politically acceptable and technically coherent are hard to identify, but need to be explored further.

Tax measures can have signiﬁcant effects on asset price dynamics, but are unlikely to be the best way to deal with bubbles.

Almost all these issues have long been recognized in the publicﬁnance litera-ture. Their importance, however, may not have been fully appreciated.

Taxes and the cost of corporate ﬁnance

This appendix explains the tax effects on the costs of retention and new equityﬁnance reported in Box 2.1 and discussed in the text.

For retentionfinance, note first that, if the company retains an additional $1 of after-tax income, this costs the shareholder $ð1 TDÞ as forgone after-tax dividend, where T_Ddenotes the rate of tax on dividends at personal level. This could have been lent out to generate interest income R that would have been taxed at rate T_P. The net income forgone is thus $ð1 TDÞð1 TRÞR. Against this, the additional internal funds generate a capital gain (taxed at rate T_G) that reflects additional future net income æ, which will generate dividends (taxed at T_D). The net benefit to retaining an additional $1 is thus

ð1 TDÞð1 TRÞR þ ð1 TGÞð1 TDÞr:

Setting this to zero gives (1.2).

For new equity, (1.3) in Box 2.1 follows from a similar argument⁵⁵except that the initial cost is in terms of funds already in the shareholders’ hands, and so is not mitigated by the dividend tax, and there are no capital gains consequences (since the share is purchased at a price reﬂecting the future earnings). Optimality thus requires

ð1 TRÞR þ ð1 TDÞr ¼ 0;

which gives (1.3). Imputation schemes of the kind mentioned in the text provide a shareholder-level credit for corporate-level taxes charged at some rate C, so that 1 TD¼ ð1 TRÞ=ð1 CÞ; if C is set at the CIT rate—‘full’ imputation—the cost of new equity is the same as that of debtﬁnance.

55The marginal cost of any form ofﬁnance today typically depends on the marginal source in the future: the latter is assumed throughout this analysis to be retentions.

3 The Role of Housing Tax Provisions

Thomas Hemmelgarn, Gaetan Nicodeme, and Ernesto Zangari

3.1 Introduction

The 2008ﬁnancial crisis hit the world economy severely. While taxes are not considered a proximate cause of the crisis, some aspects of tax policy may have led to increased risk taking and indebtedness (see Chapter 2). Tax incentives may indeed have exacerbated the behaviour of economic agents, leading them to wrong economic decisions. Among the tax factors, the widespread tax-induced bias to homeownership has attracted considerable attention, because excessive demand in the housing market, combined with lax lending practices, may have contributed to the speculative bubble in real estate prices.

This chapter proposes a detailed account of the manner in which tax provi-sions relating to the housing market may have led to the banking crisis. Mone-tary and regulatory policies opened up the possibility for a housing bubble that eventually burst and created a credit crunch because of a lack of confidence between actors onfinancial markets. Governments reacted by a combination of capital and liquidity injections, regulatory measures, andfiscal stimulus.

In most narratives of theﬁnancial crisis, the dynamics of the US housing market play a decisive role: in fact, the problems started with the housing market and theﬁnancial structure that was built on it. Not surprisingly, many commentators have found fault with some tax provisions that may have contributed to an overheated housing market. In particular, attention has

The authors thank Jean-Pierre De Laet, Vieri Ceriani, Stefano Manestra, David Pitaro, Giacomo Ricotti and Alessandra Sanelli for useful comments. This chapter was written by Mr Gaetan Nicodeme (European Commission, Université Libre de Bruxelles, CEPR and CESifo), Mr Thomas Hemmelgarn (European Commission), and Mr Ernesto Zangari (Banca d’Italia). The views expressed in this chapter are those of the authors and do not necessarily reflect the official positions of the respective institutions with which the authors are affiliated.

been focused on the tax treatment of residential housing capital gains and on the deductibility of interest expenses on mortgages.

Some commentators argue that the quasi repeal of residential housing capital gains taxation in 1997 may have fuelled the housing bubble. On the other hand, neither the OECD nor the IMF believe that this factor has played a signiﬁcant role;¹ moreover, the academic research that has analysed the dynamics of the US housing market tends to have reached the same conclu-sion (see also Chapter 2).

The role of the mortgage interest deductibility in the crisis is also controversial.

There was no relevant change in the US tax rules on this tax break in the 2000s;

the housing boom did not take place evenly across the country, although the federal tax system has a nationwide coverage. Housing prices went up both in countries where interest on mortgages was deductible and in countries where it was not or where it was deductible only within limits. Nevertheless, this tax break can be thought of as a catalyst in a chemical reaction: the deductibility did not cause the bubble, but it may have accelerated the run-up in prices. It remains true that the US regime is one of the most generous in an international compari-son; while all other countries allow interest deductibility only for acquisition or renovation of residential buildings, the US tax code extends this allowance to other purposes (‘home equity loan’); moreover, the relatively generous limits to the beneﬁt are capped on the amount of the mortgage, not on the amount of interest payments (as in all other countries). Since it is proportional to debt, the tax break is more relevant for riskier mortgages with higher interest rates and may have contributed to trigger‘gambles’ on housing, especially in the context of‘exuberant’ price expectations.

A meaningful comparison can be made between the 2008 financial crisis and the 1990s Scandinavian banking crises. In the late 1980s Norway, Sweden, and Finland experienced large credit and asset upswings, followed by severe downturns after the burst of asset prices. As in the recent US and world financial crisis, so in the Scandinavian banking crises: deregulatory measures, expansionary monetary policy, and lax risk analysis interacted and paved the way for a rapid credit expansion and increases in asset prices;² an important role was played by the housing market dynamics, which in turn were probably affected by housing tax provisions; and the asset bubbles burst when interest rates started to increase.³An interesting case in regard to the relationship between housing tax rules and financial crisis is Sweden: here the housing tax rules may have contributed indirectly to the price upswings

1 See IMF (2009a) and OECD (2009a).

2 See Englund (1999: 80).

3 The increase of interest rates was due not only to a change in the stance of monetary policy, but also to the effects of German reuniﬁcation (Englund 1999: 89).

(the ‘catalyst’ argument) and directly to the bursting of the price bubble, through the 1990–1 tax reform, which substantially reduced the beneﬁt stem-ming from the deductibility of interest payments, increasing the real cost of borrowing.⁴With respect to the Scandinavian banking crises, the USﬁnancial crisis seems to have been even more related to the housing market develop-ments; another distinctive and important feature of the current crisis regards the role of securitization (see below).

This chapter is organized as follows. Section 3.2 provides an introduction to developments of the 2008 financial crisis. Section 3.3 offers a reflection on whether specific tax provisions may have aggravated the crisis by encouraging homeownership and risky behaviour. Section 3.4 contains somefinal remarks.

3.2 The build-up to the 2008ﬁnancial crisis 3.2.1 General economic conditions before the crisis

The events leading to theﬁnancial and economic crisis that began in 2008 are heavily debated and the dust has not yet settled on the real causes of the crisis.

The arguments set out in this chapter are, therefore, somewhat speculative and subject to debate, and they will eventually be judged by history. Yet, a majority of commentators point to several elements that have facilitated an easing of credit and an increase in risk taking.

0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500

1 Apr. 1993 5 Apr. 1993 9 Apr. 1993 1 Apr. 1994 5 Apr. 1994 9 Apr. 1994 1 Apr. 1995 5 Apr. 1995 9 Apr. 1995 1 Apr. 1996 5 Apr. 1996 9 Apr. 1996 1 Apr. 1997 5 Apr. 1997 9 Apr. 1997 1 Apr. 1998 5 Apr. 1998 9 Apr. 1998 1 Apr. 1999 5 Apr. 1999 9 Apr. 1999 1 Apr. 2000 5 Apr. 2000 9 Apr. 2000 1 Apr. 2001 5 Apr. 2001 9 Apr. 2001 1 Apr. 2002 5 Apr. 2002 9 Apr. 2002 1 Apr. 2003 5 Apr. 2003 9 Apr. 2003 1 Apr. 2004 5 Apr. 2004 9 Apr. 2004

Figure 3.1. Nasdaq Composite Index, 1993–2004 Source: Yahoo! Finance.

4See Agell et al. (1995) and Englund et al. (1995).

The economic conditions in the early 2000s were characterized by the bursting of the dot-com bubble, which peaked in March 2000 and led to a pronounced decline in world stock-market indices in the following years (see Figure 3.1). The reaction of the Federal Reserve to this stock-market decline and the steady worsening of economic conditions were to reduce interest rates. Accordingly, the US Primary Credit Discount Rate was progressively lowered from 6.5 per cent at the peak of the bubble in mid-2000 to 1 per cent by mid-2003 (see Figure 3.2).⁵

A second characteristic of the world economy in the early 2000s was mas-sive inflows of capital on international financial markets. The US Capital and Financial Account is illustrative of this phenomenon (see Figure 3.3).⁶ Between 1995 and 2000 it increased from 1.54 per cent to 4.25 per cent of GDP and continued to rise in thefirst half of the 2000s to peak at 6.10 per cent of GDP in 2006. The main driver of this expansion was net portfolio invest-ment, which grew from $42.7 billion in 1998 to over $807 billion in 2007—a twentyfold increase over nine years (see Figure 3.4). As a result, in thefirst half of the 2000s the US economy was characterized by a rapid recovery in a low-interest-rate environment, despite a high degree of risk aversion in stock markets, following the tech bubble burst.

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00 5.50 6.00 6.50 7.00

1 May 2000 5 May 2000 9 May 2000 1 May 2001 5 May 2001 9 May 2001 1 May 2002 5 May 2002 9 May 2002 1 May 2003 5 May 2003 9 May 2003 1 May 2004 5 May 2004 9 May 2004 1 May 2005 5 May 2005 9 May 2005 1 May 2006 5 May 2006 9 May 2006 1 May 2007 5 May 2007 9 May 2007 1 May 2008 5 May 2008 9 May 2008 1 May 2009 5 May 2009 9 May 2009 1 May 2010

Figure 3.2. US Federal Reserve discount rate, 2000–9 Source: Federal Reserve.

5 Note that the Federal Reserve most certainly also tried to combat the economic consequences of the 11 Sept. 2001 terrorist attacks. The US economy was also in a context of low inﬂation, if not of deﬂation risk, which facilitated an ease in monetary policy.

6 The Capital and Financial Account is composed of the net capital transfers, the change in the domestically owned assets abroad, and the change in foreign-owned assets at home. It mirrors the current account (which is composed of the trade balance and the net unilateral current transfers).

3.2.2 Promotion of homeownership, deregulation, and subprime credits In their search for new places in which to invest, many economic agents saw property as a safe and more proﬁtable haven. The conditions were conse-quently slowly put in place for a housing bubble. Between 2001 and 2005 in the United States the number of houses sold increased by 41.3 per cent and the average Case–Shiller price index rose by 57.8. per cent and 43.1 per cent in

–800,000 –600,000 –400,000 –200,000 0 200,000 400,000 600,000 800,000 1,000,000 1,200,000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

$ millions

Net FDI Net portfolio investment Net banking and other flows

Figure 3.4. US Capital and Financial Account, components Source: US Bureau of Economic Analysis.

0 100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000 900,000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

% GDP

$ millions

Capital and Financial Account Capital and Financial Account balance in % GDP

Figure 3.3. US Capital and Financial Account Source: US Bureau of Economic Analysis.

nominal and real terms, respectively (see Figure 3.5).⁷In addition to favour-able economic conditions (low interest rates, large inﬂow of capital that needed to be recycled in the economy, and cold feet of investors towards stock markets), several regulatory measures also created incentives towards homeownership.

First, politicians wanted to expand homeownership, especially for poorer families. Two institutions played a particular role in this policy: Fannie Mae and Freddie Mac. The Federal National Mortgage Association (Fannie Mae) was created in 1938 under the Roosevelt administration to purchase and securitize mortgages in order to ensure enough liquidity for lending institutions. It became an independent body—albeit with implicit government guarantee—in 1968 and was complemented in 1970 by a competitor, the Federal Home Loan Mortgage Corporation (Freddie Mac), which achieved similar functions on this secondary mortgage market. The role of Fannie Mae and Freddie Mac was to purchase loans from mortgage sellers such as banks and otherﬁnancial institutions, securitize them into mortgage-backed bonds, and resell them on the secondary market, guaranteeing the principal and interest of the loan in exchange for a fee. This mechanism proved to be a powerful instrument to reﬁnance lending institutions with fresh cash and subsequently allow them to engage in additional lending

0 50 100 150 200 250

0 50 100 150 200

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Nominal (left scale) Real (right scale)

Figure 3.5. Case–Shiller house price index

Source: Shiller (2005). See<http://www.irrationalexuberance.com>.

7 See<http://www.census.gov> for data about house sales. For a description of the Case–Shiller index, see<http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices>.

activities. The US administrations also used these agencies to expand housing credit to middle- and low-income families as well as in distressed areas.⁸

Second, the US tax system contained several incentives for homeowners to increase their use of mortgages. For example, the 1986 Tax Reform Act dis-allowed consumers to deduct interest payments on consumer loans (car loans, credit card loans, and so on). This created a perverse incentive for home-owners to use or refinance their home mortgages—whose interest payments were tax deductible—to pay off their other debts or to extract cash for personal expenses. This incentive became increasingly larger because of the wealth effect of ever-rising home values. In addition, the 1997 Taxpayer Relief Act simplified the tax treatment of housing capital gains and increased in many cases the tax exemption for these incomes—giving further incentives to buy houses. The effects of the Low Income Housing Tax Credit and the 2004 American Dream Downpayment Act provided furtherfiscal and support mea-sures in favour of homeownership.⁹

In this context,financial institutions reacted by opening the credit tap, helped by more lax regulations. The 1999 Gramm–Leach-Bliley Act repealed some of the provision of the 1933 Glass–Steagall Act, which disallowed finan-cial institutions to combine commerfinan-cial, insurance, and investment activities and this might have led to more risk-prone attitudes from the part of com-mercial banks.¹⁰Risk taking was also encouraged by relaxed rules on capital adequacy and new accounting standards. The decision on 28 April 2004 by the Securities and Exchange Commission to loosen the capital rules for large financial institutions (following their request) and to let computer models of those investment companies determine the level of risk of investment (that is, de facto self-monitoring) may have led to a sharp increase in the leverage of the main US financial institutions.¹¹ This trend was also facilitated by the

8See the 1977 Community Reinvestment Act (CRA), which was extended by the 1992 Federal Housing Enterprises Financial Safety and Soundness Act and scrutinized by the 1995 New Community Reinvestment Act, or the decision of the Department of Housing and Urban Development in 2000 to order Fannie Mae to devote half of its business to poorer families, which was increased to a 56% goal in 2004.

9 The Low Income Housing Tax Credit was part of the 1986 Tax Reform Act and provides developers with tax credit for equity investment when investing in low-income units in a housing project. The 2004 American Dream Downpayment Act provided downpayment grants of a maximum of $10,000 or 6% of the purchase price of the house (whichever amount was larger) to ﬁrst-time homebuyers with annual incomes that do not exceeded 80% of the area median income.