The recent financial crisis has brought the role of fiscal policy to the forefront of American politics. On February 17th, 2009, President Obama signed an economic stimulus package worth $787 billion into law. The package combined increases in fiscal expenditures with tax cuts, raising the federal primary deficit. The purpose of this stimulus was to "boost economic activity by increasing short term aggregate demand"(Congressional Budget Office 2008).
The relationship between interest rates and business investment is a topic of interest in macroeconomics and corporate finance alike. In frictionless capital markets, an increase in real interest rates leads to a decline in investment because firms discount new projects at a higher cost of capital. Controlling for opportunities, changes in real interest rates affect firms symmetrically.
A major shortcoming of the frictionless view is that it pays no attention to how firms actually raise capital, or have raised capital in the past. Firms with high levels of short-term debt, or with maturing long-term debt, for example, must refinance at market interest rates, while the debt service payments of firms with long-term debt are determined by interest rates at the time of issuance.
This paper considers channels by which tax distortions are likely to have contributed to excessive leveraging and other financial market problems that came to the forefront during the crisis. As stressed in IMF (2009a), most tax systems embody strong tax incentives for corporations (including banks and other financial institutions) to use debt rather than equity finance—interest is deductible against corporate tax but equity returns are not—and, in some cases, for individuals to do so too. Tax distortions have also encouraged the development of complex financial instruments and structures, including extensive use of low-tax jurisdictions. Some argue that taxation, including of executive compensation, may have contributed to excessive risk-taking. Of course tax distortions did not trigger the current crisis, in the sense that there are no obvious tax changes that explain, for instance, rapid increases in debt in recent years. But tax distortions are likely to have contributed to the crisis by leading to levels of debt higher than would otherwise have been the case. Early alleviation of these distortions could have helped offset the factors that over the last few years led to higher leverage and other financial market problems.
The paper draws broad lessons for structural tax reform once more pressing concerns have subsided, arguing for firmer action on long-standing (and deep-rooted) distortions. These distortions have mostly long been recognized, but few countries have acted on them decisively. There remains much to learn, but one lesson of the crisis may be that the benefits from mitigating them are far greater than previously thought. The paper comments too on broad sequencing issues: some possible reforms could worsen the immediate outlook—but in other respects the present conjuncture may be favorable to desirable structural reforms. The analysis focuses mainly on higher income countries, which were at the epicenter of the crisis, but also has implications for other Fund members.
