Taxes, Subsidies, and Distortions

by Don Boudreaux on November 20, 2009

in Myths and Fallacies, Subsidies, Taxes

In the current New Yorker, James Surowiecki is properly critical of the economic distortions introduced by taxing debt-financed income much more lightly than taxing equity-financed income.

But his policy conclusion is a non sequitur:

Given the weak state of the economy and of housing prices, a wholesale rewriting of the tax code may be a bridge too far right now, but there are plenty of reforms—capping deductions, phasing them out over time, restricting their use by heavily leveraged companies—that would move in the right direction.

The clearest hurdle to these changes may be political, but the bigger hurdle is, in a way, psychological: because tax breaks on debt have been around so long, we can hardly imagine what it would be like if we changed them, and we tend to underestimate their influence in shaping our behavior. Subsidizing debt seems harmless simply because we’ve always done it. But the fact that you’ve had a bad habit for a long time doesn’t make it less dangerous.

It simply doesn’t follow – as a matter of logic, ethics, or economics – that, because debt-financed financial gains are taxed less heavily than are equity-financed financial gains, debt-financed gains are subsidized (as opposed to equity-financed gains bearing an undue tax burden).  Nor does it follow that taxes on debt-financed gains ought to be raised.  Eliminating these distortions can also be done by reducing taxes on equity-financed gains.

I wonder if Surowiecki believes that low-income Americans are being distortingly subsidized by high-income Americans.  After all, if failure to tax a financial gain as heavily as that gain might be taxed means that the untaxed portion of that gain is a subsidy, then it appears as if the current ‘progressive’ rates of income taxation in the U.S., in and of themselves, transfer subsidies from higher-income Americans to lower-income Americans.

If confronted with evidence of economic distortions created by ‘progressive’ income-tax rates, would Surowiecki advocate raising taxes on low-income workers as the only means of eliminting such distortions?

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  • Mike
    He seems to not notice that there is a double taxation of corporate dividends and eliminating the "tax advantage" of interest is just extending double taxation to payments for the use of debt. How is that anything but a new double tax with all the distortions that entails? If he thinks the deduction encourages excessive leverage why doesn't he propose substituting the interest deduction for making dividends tax free. Better yet, why don't they repeal the corporate income tax all together as at best the tax distorts resource allocation and at worst it is a hidden tax on consumers of the corporation's products.
  • Matt
    Am I crazy or isn't what Surowiecki was saying the exact same thing Don himself mentioned in a post a little bit ago, "Such a huge deviation from neutrality in taxing equity-financed corporate income and in taxing debt-financed corporate income cannot help but to distort financing decisions toward debt – perhaps dangerously so."
    Maybe the only point of this post is that you shouldn't call it a subsidy, but it seems Don more or less agrees. Clearly, taxing something less is, by definition, not a subsidy, but I think the point was it does the same thing as a subsidy by encouraging bad behavior.
  • davidzet
    What word would you use, Don, to describe the favorable tax treatment of debt? Would you say "subsidy" (relative to the cost of equity finance) or "marginally distorting" or ???
  • johndewey
    What are you implying, davidzet? That government automatically has a right to the fruits of our labor? and that any of those fruits we are allowed to keep is a subsidy?

    In answer to your question, I would refer to the double taxation of business income - once at the corporate level and once after profits are distributed to business owners - as confiscatory taxation.
  • davidzet
    @JD -- what are you talking about? Is that a cut and paste comment?
  • johndewey
    I'm talking about exactly the same idea that Don has written about. Who would call absence of taxation a subsidy? Only those who believe that government and not the worker has a right to the fruits of the worker's labor. You seemed to be saying you are one of those people - the people whop believe government has the only right to fruits of labor - when you referred to "the favorable treatment of debt".

    If you believe that government and not the worker has the right to the fruits of the worker's labor, then continue to refer to the "favorable treatment of debt". But if you do not hold that view, please consider referring instead to the confiscatory taxation of equity returns.

    Is that a little more clear?
  • davidzet
    So you would rather have no taxes, i.e., no government? Well, then.

    I am taking taxes for granted and talking about their treatment.

    (BTW, I am a fan of taxes on real property, neither income nor expenditures...)

    I am a Berkeley libertarian, so I do see a role for govt.
  • Not Sure
    A subsidy is a grant of money. In order for the fact that A is taxed less than B to be considered as a subsidy for A, you necessarily need to start from the position that the money involved belongs to the entity providing the subsidy.

    Are there really people out there who believe that the government is the rightful owner of their income, with first call on how it's used? Or are people confused about what subsidies actually are?
  • Gil
    If your rent an apartment does the rent you pay amount to "stealing the fruits of your labour" or "the apartment owner is the rightful owner of your income"?
  • Not Sure
    If I agree to rent an apartment for $XXX, then of course, it's not theft when I give $XXX to the owner as payment for the time I spent in the apartment.
  • Gil
    What? And when the rent rises because there's an increasing apartment shortage and tenants are the ones competing for landlords then is that 'stealing'?
  • davidzet
    We have different definitions of subsidy.

    Good luck with that.
  • Not Sure
    Subsidy:

    Merriam-Webster Online: a grant or gift of money.

    Dictionary.com: a direct pecuniary aid furnished by a government to a private industrial undertaking, a charity organization, or the like.

    Cambridge Dictionary Online: money given as part of the cost of something, to help or encourage it to happen.

    There are more just like that, but this should be enough for now.

    Of course, there's no reason you can't have your own personal definition, but it dos make it hard to have a discussion without agreeing on what words mean, don't you think?
  • vfwh
    "as if the current ‘progressive’ rates of income taxation in the U.S., in and of themselves, transfer subsidies from higher-income Americans to lower-income Americans."

    Of course they do! That's the whole point of progressive taxation. It's the richer subsidizing the poorer, as the poorer will have, for less financial contribution, equal or greater access or benefit from the services provided by the state.

    James Surowiecki's point is not about subsidies in general, it's about the bad economic sense of subsidizing debt-financed financial gains.
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