The global crisis has spawned, not surprisingly, a plethora of legislative and regulatory proposals, many requiring international agreement and co-ordination.
Politicians, understandably, want to be seen to be taking bold decisions. Yet, at the same time, better performance and judgment in boardrooms also remain an essential part of an improved finance system, for which no regulatory fiat can substitute.
In theory, the finance system could be made safe through regulation that drives out risk from key financial entities and is skewed towards the “socially useful”. But this would stifle innovation and creativity. Financial institutions should develop products and services to meet the perceived needs of clients and counterparties, with the regulator intervening appropriately to ensure institutions are sufficiently capitalised, that suitable risk management processes are in place and to constrain wider system risks.
It is not for the regulator to exercise a judgment of Solomon on what is socially useful and what is not. The desire for corrective public policy action is, of course, wholly appropriate in the wake of the damage sustained by taxpayers and, much more seriously, by wider society, through loss of output and employment. But a correct diagnosis of the disease is critical before deciding on a prescription.
This means thinking internationally. Substantial alignment and co-ordination is required if policy initiatives are to achieve their declared objectives without stimulating cross- border arbitrage or avoidance. That this is largely understood within the Group of 20 nations is to be welcomed.
In this light, it is surprising that one possible policy proposal – ending or reducing the differing tax treatment of debt interest and equity dividends, at least in financial institutions – has been sidelined. Most post-crisis policy discussion has focused on regulatory architecture, more demanding capital and liquidity requirements, restricting the scope of businesses and new tax levies.
The continuing bias towards encouraging leverage in companies, banks, private equity groups and hedge funds – because debt interest is deductible and equity dividends are not – is commonly disregarded.
The reasons are not hard to find. Reducing the tax deductibility of debt interest (TDI) lacks populist appeal, raises complex issues, could be implemented only gradually and would face huge obstacles even in the case of a big economy with little international harmonisation. Yet maintaining TDI seems perverse at a time when policymakers are committed to reducing leverage and boosting the equity base of financial entities.
Here are five possible building blocks to be considered in the context of a thorough international review: First, the main focus should be on banks and other financial entities – leverage was less of an issue for non-financial businesses before the crisis.
Second, the reduction or withdrawal of TDI should apply to institutions covered by regulatory authorities.
Third, the change to TDI would apply to funding from banks and other financial entities or capital market sources but not to funding through insured retail deposits.
Fourth, depending on the precise nature and scale of the change, the extra tax collected might permit a reduction in the tax rate or fund a complementary tax relief for equity.
Fifth, the objective of such a policy would need broad international agreement, starting with a G20 discussion and leading to the International Monetary Fund or a comparable authority undertaking a comprehensive review.
These prescriptions will require profound consideration. Those who benefit from present arrangements will lobby against dilution of their fiscal subsidy. But we must not ignore the opportunity – and the need – to re-examine this deeply embedded and powerful asymmetry in the tax system, which influences behaviour and yields outcomes in terms of balance sheet structure far removed from what public policy should be trying to promote.