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Kocherlakota: Summary - Re-thinking Leverage Subsidies - Narayana Kocherlakota

Video summary of Narayana Kocherlakota's June 27th speech in Big Sky, Montana. Re-thinking Leverage Subsidies. View the full text at: http://www.minneapolisfed.org/news_ev... Summary text: These remarks represent my views, not necessarily those of others in the Federal Reserve System or on the Federal Open Market Committee. Last July, Congress passed the Dodd-Frank Act. The Act's goal is "to promote the financial stability of the United States," and it envisions the Federal Reserve System as being integral to the fulfillment of this mission. With that in mind, I offer two observations. The first is that household leverage and financial institution leverage both reduce financial stability. Intuitively, when households take on larger mortgages, financial institutions that own those mortgages suffer greater losses from any fall in the value of the underlying home. Similarly, financial institutions are less able to survive this fall in their asset values if they are highly leveraged. Thus, leverage exacerbates the sensitivity of the financial system to declines in land prices. Secondly, the U.S. tax code provides explicit incentives for leverage. It encourages households to take on mortgage debt by allowing them to deduct mortgage interest payments from their taxable incomes. The code also encourages corporations to finance through debt by allowing them to deduct interest payments from their taxable incomes. In this way, our tax system provides incentives for activities that undercut financial stability. All tax provisions have both costs and benefits. But the recent financial crisis taught us that such crises are associated with enormous macroeconomic costs. My main conclusion is that the costs of providing tax incentives for leverage are bigger than was generally perceived prior to the crisis. What does this conclusion imply for tax policy? I suggest that policymakers should consider two changes to the US tax code. The first is to reduce the fraction of mortgage interest payments that households are allowed to deduct from their taxable incomes. The second is to reduce the fraction of interest payments that corporations are allowed to deduct from their taxable incomes. Of course, policymakers should adjust the timing of these changes in light of prevailing macroeconomic conditions.