How did bad tax policy contribute to the financial meltdown?

Tax policy and the global financial crisis

 

IT has been widely held that one of the immediate causes of the 2008/2009 US financial crisis is the subprime housing loans there, which via various ingenious financial instruments had at some point in time seriously put at risk the whole global financial system.

Policymakers, meanwhile, are engaged in a debate as to how new regulations could be introduced into financial systems to curb the assumption of excessive risk-taking and, at the same time, look into how banks and financial institutions be subjected to new capitalisation rules going forward.

One area that has not been widely looked at is the role of tax policy in the crisis.

The immediate response by many countries was to cut corporate tax rates as a short term measure to cope with the sharp economic contraction.

But how did bad tax policy contribute to the crisis?

It was only recently that the Internatianal Monetary Fund (IMF) and the Organisation for Economic Cooperation and Development (OECD) produced two reports in response to the questions: “What aspects of the tax system has helped cause or exacerbate the crisis, and whether tax policy needs to be reevaluated” in light of what has happened.

The reports looked at the US income tax system and lessons can be learnt from them since our own system can adopt some of these policy initiatives.

Preference for debt vs equity financing 

This is seen as an obvious link to the crisis.
When a company wishes to finance its business, should it look to borrowings (debt) or should it finance through capital (equity)?

Most tax systems, including Malaysia’s system, favours debt financing over equity financing because of the deductibility of interest payments and the non-deductibility of the cost of equity capital.

Thus, this obvious bias for debt financing is recognised particularly at the corporate level.
With the surge in corporate borrowings in the last decade or so, including leveraged buyouts and the intense activities of private equity funds, the possibility that this bias may have contributed to the risks in the system is a serious consideration.

There is little doubt that under such a bias system, corporate finance will always respond positively to tax considerations.

This tax preference for debt has been long-standing and widely recognised by tax practitioners, something which could make an otherwise non-profitable investment profitable.

The position in Malaysia so far seems to reflect the common bias towards debt financing although the introduction of thin capitalisation rules, which are being awaited, could change that scenario.

The US housing bubble

The bubble is generally understood to have been the effect of increased household borrowings and high house prices.

The tax rule in the United States allows mortgage interest taken out on a home to be fully deductible against income from employment earnings.

Thus with the expectation of increases in home prices, this has raised the expected returns on borrowings to purchase houses.

Analysts believe that this could be a contributing factor but are unable to point to empirical evidence, given the range and complexity of the various instruments that were in place when the bubble burst.

Tax planning and lack of transparency

The need to give further study to this possible link is recognised - that the development of complex financial instruments could in part be spurred by the tax avoidance opportunity that could arise.

Thus, swaps have been used to avoid withholding tax.

The use of offshore low tax jurisdictions to hold funds has helped create an opaque environment.
The G20 initiatives last year in curbing such practice have seen countries with low tax jurisdictions responding to a global initiative to conclude agreements for the exchange of information.

Malaysia is a signatory to such agreements.

Restriction in the transfer of tax losses 

This refers to where losses are not available for carry-forward in the case of a change in ownership.
Economists see this rule as lacking neutrality as they have always argued that tax losses should be refunded or at least be allowed to be carried forward.

The further argument is that such restriction acts as an impediment to efficient acquisitions. The similar restrictive rule in Malaysia, although introduced in law, has been modified in its operation.
This is particularly helpful.

The widely held practice under a VAT (value added tax)/GST(goods and services tax) regime to exempt financial services is seen as a bias towards households using financial services.

What it means is that it encourages consumers to borrow rather than save until they are able to pay for fully-taxed products.

Malaysia’s GST tax rules, which have yet to be enacted, appear to have adopted the same exemption although details as to how these would operate are not yet known.

Conclusion 

The adoption of the New Economic Model (NEM) is perhaps an opportune time to look at our tax policies. New policy approaches should be in sync with the NEM. For example the implementation of the GST, if accompanied by a marked reduction in the corporate income tax rate, should get rid of the bias towards debt. The loss of tax revenue could be made up by higher GST collections from an increase in per capita income, a key aim of the model.

Kang Beng Hoe is executive director of TAXAND MALAYSIA Sdn Bhd, a member firm of the TAXAND Network of independent tax firms worldwide. The views expressed do not necessarily represent those of the firm. Readers should seek specific professional advice before acting on the views.