11.20.2009 Policy Points

Public Policy Promotes Debt

Popular discussions about debt often portray the issue in individual terms and make little mention of the economic forces that may lead individuals and firms to incur debt (e.g. flat wages coupled with rising living costs; tight credit) or the the public policies that actually encourage firms and households to borrow.

Writing in The New Yorker, James Surowiecki analyzes how the federal tax code encourages debt by subsiding its costs in various ways. Observes Surowiecki:

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.

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