James Surowiecki explains to a lay audience how the tax code encourages debt:
John Kenneth Galbraith wrote that all financial crises are the result of “debt that, in one fashion or another, has become dangerously out of scale.” The recent financial crisis was no exception, with everyone — homeowners, private-equity investors, our biggest banks — taking on enormous amounts of debt. If it’s frustrating that the government is footing the bill to clean up the mess, it’s even worse that the government helped pay for the debt binge that created the mess in the first place, thanks to a tax system that actually subsidizes borrowing. Debt didn’t get dangerously out of scale because the system was broken. It got out of scale, in part, because the system worked.The government doesn’t make people go into debt, of course. It just nudges them in that direction. Individuals are able to write off all their mortgage interest, up to a million dollars, and companies can write off all the interest on their debt, but not things like dividend payments. This gives the system what economists call a “debt bias.” It encourages people to make smaller down payments and to borrow more money than they otherwise would, and to tie up more of their wealth in housing than in other investments. Likewise, the system skews the decisions that companies make about how to fund themselves. Companies can raise money by reinvesting profits, raising equity (selling shares), or borrowing. But only when they borrow do they get the benefit of a “tax shield.” Jason Furman, of the National Economic Council, has estimated that tax breaks make corporate debt as much as forty-two per cent cheaper than corporate equity. So it’s not surprising that many companies prefer to pile on the leverage.
Eliminating the business-interest deduction is a political non-starter, he notes, but the equivalent option should be quite welcome: expensing all distributions to investors — dividends, etc. — who would then pay income taxes on them. This effectively eliminates double-taxation of corporate profits.