By Steven K. Beckner

WASHINGTON (MNI) – Minneapolis Federal Reserve Bank President
Narayana Kocherlakota suggested Monday that the U.S. economy still has a
long way to go to recover from the financial crisis and said that
significant changes in the tax code are needed to reduce the kind of
excessive risk-taking that led to the crisis.

“You are all very aware that our country has gone through a
difficult financial crisis and that we are still only beginning to make
our way back from its impact, he said.

Kocherlakota, a voting member of the Fed’s policymaking Federal
Open Market Committee, did not otherwise talk about the outlook for the
economy or for monetary policy in remarks prepared for the Tri-State
Bankers Summit in Big Sky, Montana.

Last month, he called for raising the funds rate 50 basis points
before the end of the year, but only under certain assumptions — that
core PCE inflation continues to run at the 1.5% first quarter pace and
that the unemployment rate fall to 8-8.5%. If inflation falls, he says,
the Fed would need to “ease further.”

Kocherlakota traced the financial crisis to the run-up and
subsequent collapse of land prices, which he in turn blamed in good part
on leverage incentivized by the tax code.

He made three main points:

— “First, the sharp and largely unanticipated fall in U.S.
residential land prices after 2006 was the main cause of the financial
crisis of 2007-09.”

— “Second, household and financial institution leverage exacerbate
the sensitivity of the financial system to declines in land prices and
so reduce financial stability.”

— “Third, the U.S. tax system promotes leverage on the part of
households and financial institutions.”

Fed officials often shy away from making recommendations on tax
policy, but Kocherlakota said “Congress should modify the U.S. tax
system to reduce the incentives for destabilizing activities by banks
and households.”

He said the financial system would have been less susceptible to
the financial shock of plung land and home prices if home buyers had
made larger downpayments — 20% instead of 10%; if banks had had less of
their assets concentrated in residential land and if banks had lower
debt to equity ratios.

Kocherlakota blamed the tax code for causing both households and
financial institutions to rely too heavily on debt finance by allowing
full deductability of interest on debt.

“The tax system provides an extra incentive for any given
household to take out the larger loan,” he said. “Under the current tax
code, the household can deduct from its gross income any interest
payments it makes on the extra $90,000 of mortgage debt.”

“This means that the household’s after-tax interest rate on its
mortgage is lower than it would otherwise be, making mortgage financing
more attractive,” he continued. “It is in this sense that the mortgage
interest tax deduction undercuts financial stability.”

Then too tax considerations play a big role in how banks and other
corporations finance their activities, Kocherlakota observed.

“If it chooses the debt route, the bank can deduct its interest
payments from its earnings before paying any corporate income taxes,” he
explained. “If it chooses the equity route, then the financial
institution must make its dividend payments from profits that are left
after it pays corporate income taxes. Debt repayments are cheaper.”

“In this way, the tax code includes what is known as a corporate
debt tax shield that encourages higher leverage for financial
institutions,” he added.

So Kocherlakota recommended two changes:

— First, “lower the fraction of mortgage interest that households
can deduct from their taxable incomes.”

— Second, “lower the fraction of their interest payments that
corporations are allowed to deduct from their taxable incomes.”

He said it would be “appropriate and important to adjust the timing
of these changes in light of prevailing macroeconomic conditions.”

Kocherlakota said those two changes could be accompanied by other
offsetting changes in the tax code to reduce their sting while
preserving the benefits of reduced leverage.

If policymakers wanted to continue to encourage home ownership, he
said, they “could consider replacing the mortgage interest deduction
with a tax credit that offsets part of a buyer’s down payment toward a
home purchase. Such a tax credit would encourage home ownership without
simultaneously providing more incentives for households to accumulate
more debt.”

Similarly, policymakers “could consider replacing the corporate
interest tax deduction with a lower corporate income tax rate. The lower
corporate income tax rate would encourage business investment without
simultaneously providing incentives for corporations to acquire
leverage.”

Kocherlakota said he agrees with Fed Vice Chairman Janet Yellen
that regulation of systemically important financial institutions under
the Dodd-Frank Act needs to be strenthened, but suggested that tougher
regulation without such tax changes would be inadequate.

** Market News International **

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