THE field for the title of world’s worst economic distortion is a crowded one. Fuel subsidies in the emerging world are one contender; the implicit government guarantee that props up big banks another. But it is a less noticed and more pervasive warping of the economic fabric that is the most damaging. Despite the fact that the world is mired in debt, governments make borrowing costs tax-deductible, cheapening debt and encouraging borrowers to pile on more.

Tax breaks for debt come in two principal forms. Interest payments on mortgages are tax-deductible for personal tax purposes in at least some way in America and over a dozen European countries, including Belgium, Italy, the Netherlands, Spain, Switzerland and most Nordic states. And across the world firms can deduct interest payments to debt-holders from their taxable earnings. In contrast the dividend payments and retained profits that flow to shareholders are taxed in most places.

The global convention that debt should enjoy tax perks emerged as much by accident as design.

Its original proponents could not have imagined the scale of debt that now exists (global debt stands at 286% of GDP today). Britain made interest paid by firms tax-deductible in 1853.

America allowed the partial deduction of interest for firms in 1894, a decision which was overturned as part of a Supreme Court ruling in 1895. A muddle of laws, judgments and a constitutional amendment partly restored the interest deduction in America from 1909 to 1916.

One aim was to help the indebted railroad industry. The full deductibility of interest was eventually permitted in 1918 as part of a package to help companies struggling with the effects of the first world war. Mortgage-interest deduction was allowed in 1913, at a time when few Americans had mortgages. It was only after the second world war that this perk became associated with the political aim of boosting home-ownership.

Today, tax breaks for debt are embedded in all economies and viewed as the natural order of things. For a half-accident of history they have grown mighty big. There are three ways to demonstrate their scale. First, their cost in forfeited tax revenue soared to between 2-5% of GDP a year in the rich world just before the crisis. In 2007 Britain and the euro zone spent more on subsidies for debt than on defence.

Second, the value of tax breaks is large relative to the assets they are linked to. In America their present value (the value in today’s money of the potential tax benefits for borrowers) equates to perhaps 14% of the value of the stock of homes and 11% of the assets of firms. These calculations discount the tax saved by 3%, the yield on long-term Treasuries, and exclude the benefits accruing to financial firms and to partnerships.

A third way of showing the size of the tax distortion is to see how it affects the calculations that borrowers make. The annual interest payments on a $1m mortgage can be reduced by over a quarter as a result of interest deductibility. A big American firm typically pays an after-tax interest rate of 3% on debt, while the cost of equity (based on the annual return that shareholders expect) is 8% or more. About half of that gap is explained by tax breaks.

Colonel Mustard, with a subsidy
 
Debt subsidies did not cause the financial crisis. Corporate-tax rates in many countries fell in the run-up to the crash, lowering the potency of the tax perks. Most multinationals run solid balance-sheets. In America rich households get much of the benefit of the mortgage-interest relief—and few of those defaulted.

Yet a bias in the global tax system probably made the crisis worse, says Simon Johnson of the Massachusetts Institute of Technology. It boosted the overall level of debt and created pockets of distress. The Netherlands had the world’s most generous tax subsidies of mortgages, worth 2% of GDP a year, more than double the level in America. It built up one of the highest levels of mortgage debt, which still hangs over the economy. And many corners of the corporate world took lots of risk.

Leveraged buy-outs and commercial real estate relied on heavy borrowing, made cheaper by tax breaks, and generated heavy losses. In the latest stress tests conducted by the Federal Reserve and European Central Bank, the corporate sector accounted for 30-40% of expected banking-system losses.
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Banks, inevitably, took most advantage, gaming the tax rules with devastating results. Most issued “hybrid” securities that were treated as debt by the taxman but as capital by credulous regulators. In the crisis hybrids did not act as a buffer that absorbed losses. About a third of big Western banks’ capital was made up of these instruments. Had they raised equity instead, fewer banks would have wobbled, says Ruud de Mooij of the IMF. The resulting financial crisis left a debt burden that largely remains (see chart 1).

I’ll be at your side forever more
 
None of this is to deny the importance of debt. It serves many useful economic functions. It allows money to travel through time and across social divides. A firm that is short of cash but that has good prospects can raise funds and repay them tomorrow. A rich or frugal person with more money than they wish to spend can lend to those whose outlays exceed their income.

Bosses like debt because it allows them to raise funds while keeping full control of their firms, as long as they meet their payment schedule. Savers like to own bonds or make loans because those interest payments are usually a safe stream of income. If the borrower gets in trouble, creditors have first claim on their assets. Debt can take complex income streams and make them regular. Everything from Korean shipbuilders’ cash flows to the royalties from David Bowie’s song, “Space Oddity”, have been fashioned into bonds offering predictable payment schedules.

Nor is there a logical limit to the amount of debt. One man’s debt is another’s asset. Global debts should cancel out to zero. A thicker web of debt contracts is taken as a sign of economic sophistication, not impending insolvency. “Credit is the vital air of the system of modern commerce,” said Daniel Webster, an American senator, in 1834. “It has excited labour, stimulated manufactures, pushed commerce over every sea.” Emerging economies have long been told that “financial deepening” is essential to pay for the new roads and factories that they need.

Beyond a certain point, though, debt seems to be bad for the economy. The Bank for International Settlements (BIS), a club of the world’s central banks, reckons the threshold is 85% of GDP for household debt, and 90% of GDP for non-financial corporate debt. Most rich countries breach, or are close to breaching, at least one of those benchmarks.

Excess debt hurts growth in two ways. In the rich world most new debts do not finance new productive assets like factories or machines; they just reshuffle claims on existing assets. But these debts still need a big financial industry to administer them, says Stephen Cecchetti, now of Brandeis International Business School and before of the BIS. That sucks resources from the rest of the economy.

Debt also hurts growth by creating fragility. Fixed payments mean that households and firms are more sensitive to downturns, cutting their spending deeper and faster in response, or going through disruptive defaults. The economy’s middle-men—banks—create a second layer of trouble since their solvency is especially sensitive to shocks. If banks have lots of short-term debt that needs to be rolled over, then they become vulnerable to runs.
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The fragility of debt stands in contrast with another financial instrument—equity or shares.

Unlike interest, the dividends paid to equity holders can be cut if things go wrong, without triggering a default. Equity does not expire, so does not need to be refinanced. The benefits of this flexibility were shown in the 2000-02 dotcom stockmarket crash. The losses then were $4 trillion, more than the $2 trillion global banks suffered in 2007-10. Yet there was no credit crunch. In a crisis, equity bends while debt breaks. Despite this, equity has been a fading form of finance in the rich world. The net amount of corporate equity issued in America has been shrinking for a decade. In contrast, between 2007 and 2014, debt in the non-financial sector—governments, households and firms—rose in 41 of 47 of the planet’s big economies, relative to their GDP, says Richard Dobbs of McKinsey, a consultancy (see chart 2).

The closest there is to a rule governing the right level of debt is the theory of Modigliani and Miller. It says that the capital structure of a firm cannot alter its value (assuming a world without tax). Its operating profits and riskiness remain the same, no matter how its funding is sliced and diced into equity, debt or other instruments. The theory does not specify what the right level of debt or equity might be but it makes clear that firms should not regard one form of financing as better than the other. Broadly speaking the same principle should apply to household balance-sheets too.

Yet in the real world, there is a strong bias towards debt. What explains this? The tax break is one factor, but not the only one. The bias also reflects the wiring in humans’ brains. Savers are prone to think that the fixed flow of payments offered by debt is safer than it actually is. When asset prices (in particular property) rise, borrowers are tempted to think that they will rise further and use debt to buy more assets in order to magnify their profit.

The bias towards debt created by tax and psychology has been amplified by powerful forces in the global economy that have led to more financial deepening, says Adair Turner, a former chairman of Britain’s Financial Services Authority and the author of a forthcoming book called “Between Debt and The Devil”.

Consider global imbalances, first. Exporters such as China build up savings and invest them abroad. In theory they could buy equities. But had China invested its foreign reserves in American shares, it would now own about a fifth of the S&P 500 index and have de facto control of corporate America, a politically impossible position. So the exporting countries bought safer and less controversial debt instead—75% of the rise in foreign ownership of American securities between 2004-08 was in the form of debt, most of that mortgage and corporate bonds.

Income and wealth inequalities within economies also amplify the impulse towards debt. Rich people have a lower propensity to spend than most, so the more they earn the more they save.

That money has to be recycled into the financial system, creating more financial instruments.

Those in need of capital are often poor people with stagnant incomes. In practice debt is the only way to funnel money to them. You cannot, after all, buy shares in a household. Subprime debt secured against houses seemed safe.

A third and final accelerant is the financial industry. Its natural impulse is to create new instruments to drum up business. And it much prefers creating debt to equity. Debt is the magic ingredient that makes modern finance possible. Risky cash flows can be packaged into apparently steady payments, making it easy to reassure—or deceive—customers. Arbitrage (exploiting differences in price between similar assets) is only profitable if magnified by leverage. By using layers of debt with different seniority, risk can be transformed in almost infinite ways.

The financial industry also has its own distortions that encourage it to issue debt on its own balance-sheet. Banks—and in America, the housing agencies Fannie Mae and Freddie Mac—proved to be government-backed, an implicit guarantee that makes their borrowing costs artificially low. What is more, bank executives are often paid on the basis of badly designed profit measures, such as return on equity, that are flattered by leverage. All of which means that debt would retain some of its allure even without the tax breaks.

If you take a walk, I’ll tax your feet
 
Some, but not all. So what would happen if these subsidies were removed? It would be a revolutionary step because the breaks are embedded in the way firms and homebuyers behave.

That suggests it would cause some short-term disruption. But the longer-term pay-off could be immense.

Start with the short term. So far as withdrawing mortgage relief goes, the historical examples are muddy. Britain’s mortgage-related tax perks contributed to a house-price boom in the 1980s but their abolition in 2000 did not stop another bubble from inflating. The sheer complexity of today’s financial industry adds to the murkiness. But it seems likely that there would be an initial jolt to house prices if the subsidy were withdrawn. The Netherlands saw a price drop of about a tenth when it cut mortgage subsidies in 2012. An equivalent drop is likely in America given the value of the subsidies relative to the housing stock. The direct pain would be felt by the well-off—almost 90% of the value of the mortgage-interest tax break goes to households making over $75,000 a year. But lower house prices would be uncomfortable given that 17% of households have negative equity. The same is true in the euro zone, which is battling deflation.

As for corporate tax, much would depend on how policymakers went about reform. The purest option is to abolish corporate tax entirely—and instead have one layer of tax levied on the income individuals receive from investments in firms. That would remove a vast amount of complexity from the system and limit the incentive for tax-dodging and lobbying by firms. But cutting corporate taxes would be politically toxic at a time of stagnant wages for many workers around the world.

Two alternative approaches exist. The first balances the scales between debt and equity by levelling down: creating an equivalent tax break for shareholders. This system, which is in place in parts of Europe and is known as the “allowance for corporate equity” (ACE), permits firms to make a certain level of profit without incurring tax. The trouble is that, on its own, it would lead to a drop in tax revenues—Belgium introduced ACE in 2006 and saw corporate-tax revenues halve. It has recently introduced a “fairness tax” to try to recoup some revenue.

The second approach balances the system by levelling up: making interest taxable on the same basis as shareholders’ profits. This would hugely expand the tax base, allowing a drop in the headline tax rate. Robert Pozen of Harvard Business School reckons that if firms could only deduct two-thirds of their interest costs, the headline rate of corporate tax in America could be cut from 35% to 25% while keeping tax revenues stable. Using his figures, were interest-deductibility to end completely, the tax rate could fall to about 15%.

On paper, the impact on firms of either approach should be small. If the absolute tax take from firms remained unchanged, then their enterprise value (debt plus equity) would be unaffected.

Firms’ underlying cash flows and risk profiles would be the same. Companies would simply rejig their mix of debt and equity.

In the real world, things would be bumpier. An ACE system might boost firms’ values, since the aggregate tax bill might fall. The alternative approach of taxing interest would be more disruptive—although not to big non-financial firms. Were interest deductibility to be abolished and the tax rate cut so that tax revenues were flat, only 8% of the S&P 500 index of American firms, and 6% of the top 2,000 global firms, would see their profits drop by over a fifth (excluding financial firms).

But outside the public markets, taxing interest would bash a cohort of firms with low margins or that have over 75% of their balance-sheet funded by debt. In America the obvious victims are utilities, cable-TV firms and commercial real-estate firms. Many leveraged buy-outs would be in trouble. One private-equity chief warns, “You’re opening up a Pandora’s box…It would cause massive disruption and market turmoil.” Firms might rush to list their shares and issue new equity, causing the overall stockmarket to fall in the face of the extra supply of shares.

Taxing interest would hurt bits of Main Street, too. Small firms find it hard to raise equity.

Farmers would find it more expensive to get loans to smooth the seasonality of their incomes. In Europe and Asia indebted holding companies are often used to control corporate empires: some of these structures would wobble.

The financial industry would be profoundly affected. Assume that banks were taxed on the interest paid on their debt (but not on their deposits), and the headline tax rate dropped by a third. For HSBC, a global bank, profits would not have changed much last year. But that reflects the fact its cost of debt is close to zero. At some point central banks will raise rates.

Were HSBC’s cost of debt to rise to 5%, the tax change would wipe out a quarter of its profits.

It would have to charge its customers more.

Whichever tax reform took place it would prompt a flurry of evasive action. Financial firms would try to reclassify their debts as deposits. Unless governments tried to unify their corporate-tax and personal-tax codes, businesses would change their legal status to evade tax.

For example, if interest were taxed, more American firms might become “pass through” entities such as partnerships, where tax is levied at the personal, rather than corporate, level.

And unless the reform was global, multinational firms would surely try to issue debts in countries that still offered tax relief. A vast edifice of cross-border finance contracts would be rearranged.
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INTERACTIVE: See more countries and their debt over time

Dismantling the doomsday machine
 
In the long run, however, the rewards from reform could be great. The surge in debt seen since the turn of the century might be halted (see chart 3). A neutral tax system would tilt the world’s balance-sheet away from debt towards equity. It would appear more volatile—like a corset, debt masks nature’s wobbles—but actually be more flexible. The pillars of the financial system—borrowers, savers and financial intermediaries—would all work differently.

Today four-fifths of the stock of global financial assets is debt or deposits. This mix would change, with more shares being issued and new equity instruments being invented. There would be a wave of experimentation with equity-linked mortgages, in which a share of the risk of a house-price change is assumed by lenders or third-party investors. Today these products are penalised by the tax system, says Jason Furman, the chairman of the Council of Economic Advisers at the White House. “Landlord companies” might emerge that listed their shares and invested in the equity of people’s houses.

Savers would join a modern cult of equity. Today pension and insurance funds are obsessed with debt, egged on by regulators who ask them to hold “safe” bonds regardless of their price.

In this brave new world, savers would have to get used to owning equity products whose price moved up and down. Dividends from shares would replace interest income from bonds. Those payments could be cut in a downturn—in 2008-09 American dividends dropped by a fifth. That would prevent a crisis but hurt pensioners who live off investment income.

Borrowers would have to change their ways, too. Lower house prices would help the young and poor, but they might find it harder to get conventional mortgages. Renting is one alternative—the 20th century’s obsession with home-ownership might ebb. Allowing third parties to own a share in a home might be another. Companies would issue more shares. It is hard to see any big downside to this. A more equity-focused culture might help younger firms get up and running, perhaps one reason why Marc Andreessen, a venture capitalist in Silicon Valley, backs tax reform.

Lastly, the financial system would have to shift its emphasis towards arranging equity contracts between savers and firms and households. This would be far easier in America, where capital markets dominate—getting mutual funds to buy stocks instead of bonds is relatively simple. In Europe and Asia, where banks suck up most savings and recycle them as loans, the process would be harder. But around the world banks would shrink.

Reforming the bias in the tax system is not the stuff of public campaigns. A vast web of contracts has been woven around a fiscal technicality, guarded by huge vested interests.

America last seriously considered the idea in 1992, and beyond some tweaks to the tax code in
Belgium, Britain, Italy and the Netherlands, there has been little sign of reform. But the moment for change may never be better.

Interest rates are low, profits are high and house prices stable. As rates increase from rock-bottom levels, interest costs will rise, inflating the size of the distortion. The tax subsidy on the vast debts of rich countries will head back towards the levels seen just before the crisis in 2008.

And the debt machine will kick into overdrive again.