Taxation in the name of equity

In his State of the Union address last night, President Obama announced a variety of proposals spanning education, housing finance, and the tax system. On that last topic, the president suggested several changes to the federal tax system, including raising the long-run capital gains tax rate. But perhaps the most interesting tax proposal was a tax on borrowing by banks with assets of at least $50 billion. The tax would raise funds, but its larger impact would be on the borrowing behavior of these large banks. A reduction in borrowing would be a boon to economic stability, with the costs borne by some of the best-off people in the U.S. economy.

First, a step back to understand the role of borrowing for banks. Broadly speaking, a business is funded either by debt or equity. Debt is borrowing, either in the form of a loan from a bank or the sale of a bond. Equity is a way to finance a firm by selling an ownership stake in the firm. An equity stake in a firm is better known as a stock share. The main difference between debt and equity is that equity is a much more flexible form of funding. If a business takes a hit to their revenue and they were expecting to pay stockholders a dividend they can just wait until revenues increase. Their valuation may decrease, but the business isn’t immediately in peril. But if this business has to make a debt payment, they must make the payment at the agreed upon time or risk default.

The mix of these two financing options determines the leverage ratio of the firm. The more levered a firm, the more debt the firm has taken on. The higher the ratio, the more profit a company can make on a given amount of earnings. But a higher ratio means that the impact of a loss is amplified. Leverage, in other words, acts like a financial accelerant.

While most businesses take on some leverage, banks as an industry have very high levels of leverage. By taxing borrowing, the Obama administration proposal would attempt to reduce these leverage ratios by discouraging debt and increasing financing through equity.

While this shift might reduce financial instability, how would less borrowing affect the rest of the economy? We often hearing about increased equity funding for banks referred to as banks “holding more capital.” Wouldn’t that mean banks are reducing lending?

The answer is no. Economists Anat Admati of Stanford University and Martin Hellwig of the Max Planck Institute document in their book “The Bankers’ New Clothes” and elsewhere that increased equity funding of banks doesn’t reduce lending. Banks aren’t holding money they already have. They are changing where they get the money from in the first place.

Increased reliance on equity wouldn’t reduce lending, but it would end up reducing bank profits, according to Admati and Hellwig. So there would be some losers from the shift. But the reduction in profits would likely be passed onto stockholders, most of whom are concentrated among at the top of the income ladder. The damage wouldn’t be severe.

The bank borrowing tax proposal isn’t the only way to get banks to reduce their debt financing. The Federal Reserve has required lower leverage ratios in the years since the financial crisis of 2008 and could go further. Regardless of the means, reducing banks’ reliance on debt would be a positive step toward equity, in every sense of the word.