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Want stimulus? Scrap special tax breaks

March 5, 2012: 5:00 AM ET

Our tax system helped get us into our economic mess. Now it can help get us out.

By Sheila Bair, contributor

FORTUNE -- As we undertake the annual mind-numbing rite of filling out our tax returns, let us pause to reflect on the role our tax code played in the financial crisis.

What brought us the crisis? Overly leveraged financial institutions made high-yield mortgages to overly leveraged consumers. Financial institutions then concocted trillions of dollars of complex securities based on those mortgages and sold them to yield-hungry investors.

And the tax code encouraged all of it.

Let's start with investors. Under our tax code, if you work for a living, your tax rate goes as high as 35%, but if your earnings come from capital gains or dividends, you have to give up only about 15% to Uncle Sam. The rationale for this $90-billion-a-year tax benefit is that it spurs job-producing investments, though there is little credible economic evidence that this is the case. Equally likely is that it contributes to a glut of investment dollars searching for return, with too few opportunities in the "real" economy. So we create incentives for banks to come up with an endless array of complex "structured" financial products to meet investors' insatiable demand for return. Just how many jobs did all of those CDOs-squared give us anyway?

And what does this tell young people? Get a job and find the cure for cancer, and we will tax you at 35%. But hey, go manage a hedge fund and only pay 15%.

Next, consider the perverse incentives the tax code creates for our banks. Interest paid on debt is fully deductible, while dividends paid to shareholders are not, making it cheaper for banks to fund themselves with debt than equity. Prior to the crisis, the industry lobbied regulators to let them finance more of their operations with borrowed money. Some regulators succumbed. As a result, many banks lacked the capital to absorb losses when the crisis hit.

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Finally, the tax code gives homeowners every reason to borrow to the hilt. A dirty little secret of the crisis is that the majority of toxic mortgages were not made to expand home ownership. They were refinancings aggressively marketed as a tax-advantaged way to pull cash out of a house. For most homeowners, interest on their mortgage is fully tax deductible, while interest on a credit card or other consumer loan is not. With an overheated market providing artificial gains in home prices, why not use your house like a credit card?

So here are some ideas to fix this mess.

Instead of making the tax code even more complex with a "millionaires tax," let's just end special breaks for capital gains and dividends, and tax everyone at the same rate, regardless of whether they work for a living or clip coupons.

For banks and other corporations, let's treat debt and equity equally by allowing some portion of both interest and dividends to be tax deductible.

And let's get rid of the $100 billion tax break for home mortgages. Canadians have no mortgage interest deduction, yet they have comparable rates of homeownership and fewer leveraged homeowners. For those who worry this would hurt our already suffering real estate market, let's give homeowners a tax credit based on how much original mortgage principal they pay down each year, including some credit for a down payment when buying a home. This could stimulate housing demand.

Finally, let's use any savings from these measures to lower everyone's rates, which will strengthen the economy. It's time to stop providing special tax breaks based on political sound bites. Where is the hard evidence that any of them promote home ownership or job creation?

Unfortunately, neither the President's new plan nor those put forward by the GOP candidates really addresses the role of the tax code in our financial crisis. What we need are fundamental reforms that make the tax code simpler and fairer to reinforce the country's core values of thrift and hard work. And give ourselves a more stable financial system in the process.

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About This Author
Sheila Bair
Sheila Bair
Contributor, Fortune

Sheila Bair is a Fortune contributor, and a former chair of the FDIC, and former member of the Basel Committee. She is also the author of the New York Times bestseller Bull by the Horns, Fighting to Save Main Street from Wall Street and Wall Street from Itself.

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