Why does America encourage debt?

America (and the world!) is now being punished for its relentless accumulation of debt during the housing bubble and before. Commentators of all stripes have laid blame for the credit bubble, whether upon Alan Greenspan, lack of regulation, greedy Wall Street, or otherwise.

But it’s interesting to note that US credit bubble has in fact been building for decades, as shown here:

US Household Debt to GDP Ratio
US Household Debt to GDP Ratio

I have a basic question: Why does America encourage debt? Both individual and corporate debt are encouraged through federal and state law, through mortgage interest deductions for individuals, and through similar deductions on interest payments by corporations.

The home mortgage deduction is a relatively recent invention, while business interest has been deductible since the advent of the income tax. Both deductions encourage us to borrow and increase leverage – and as we know now, leverage cuts both ways. The home mortgage deduction raises home prices and encourages Americans to take on excess debt. But what about the business interest deduction?

Businesses can typically raise money by either borrowing it or by selling equity in their business. Since borrowing is subsidized through a tax deduction, this encourages businesses to borrow money rather than selling shares to raise money. The downside is apparent in hard times: creditors demand repayment, whereas equity investors share in both gains AND losses*.

The home mortgage and business interest deductions formed the foundation of the credit bubble by creating a tax benefit for borrowing rather than saving.

These deductions also collectively cost taxpayers $250 Billion** per year, more than the Iraq war and almost as much as Medicare. Perhaps the next Administration should consider restoring the balance of incentives between saving and borrowing as part of its tax reform initiatives. While an immediate end to these preferences is impractical, a phased reduction coupled with broad-based tax relief might help transform America back into a nation of savers.

*From a business perspective, interest has always been treated as just another business expense, and is thus deductible just like the electric bill. But debt and equity are often competing forms of ownership in a business, and so making interest deductible makes debt more appealing than issuing shares. For example, a a pizza shop could borrow $10,000 for a renovation and deduct the interest as a business expense, or it could bring in a partner to buy 10% of the business in order to raise capital. If the owner of the pizza shop brings in a partner, he doesn’t get a deduction, and now he has to share any additional income with his partner. Thus debt is favored over equity – this principal is even taught in business schools.

** The home mortgage deduction costs totals $100 Billion per year, while the business interest tax deduction can be estimated at $150 Billion per year with total corporate debt of $10 Trillion, an average interest rate of 5% (conservative estimate), and a corporate tax rate of 33%.

4 thoughts on “Why does America encourage debt?

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