Tax Treatment of Debt

Various commentators and parties have recommended that landlords should not be able to deduct interest payments on debt in calculating taxable income.  More generally, ending the favourable tax treatment of debt is one of the central recommendations from the IMF, in its recent analysis of how macroeconomic policies should change in the wake of the global financial crisis (paper is here).  By favouring debt over other funding options, the tax deductability of interest charges encouraged excessive leverage and thereby contributed to risk in the financial system.

Accordingly, tax reform in this area has the potential to improve allocative efficiency while also raising revenue.  No doubt the shift to a new system must involve a transition phase, such that the initial improvement in revenue may be limited.

3 thoughts on “Tax Treatment of Debt”

  1. Take the case of residential property investment alone.

    The way that investment in properties and tax deduction works is honestly a bit nuts. It drives acquisition, even at ridiculously high prices. This is actually probably the key factor in the housing bubble. I think the ECB had an impressive paper on this, mid-boom, where they argued that tax policy, rather than interest rates was the driver behind property bubbles, but I cannot find it quickly.

    To a large extent, removing the incentive now is an example of post-egress barn-closing.

    But the government has to decide how it wants to structure the housing market. If it wants to have large, professional landlords, then keeping the system, or modifying it might be the way to go. If home ownership and small-scale landlording is the plan, then it should get rid of or greatly limit the tax break.

    In a few years time, we may find ourselves in a position where it is difficult to convince developers and banks to fund new housing. This sounds ridiculous now, but it might still be true.

    Probably the most sensible thing will be to have a policy that encourages investment in ‘sensible’ housing, that is medium-to-high-density and that is sustainable in other ways.

    The decisions the government makes on things like this will shape our country for years to come. It bears a little bit of thinking.

  2. Most of the comment on the property boom and subsequent crash has been on its financial effects, but there is another side. It may be that many recent immigrants will return home permanently, with the result that there will be a lot of empty properties for some time to come.

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