Paul Volcker Taught Us How Tax And Monetary Policy Can Work Together To Enhance Growth

The recent passing of former Federal Reserve Chair Paul Volcker serves as an important reminder of his critical role in ending stagflation in the late 1970s and early 1980s. But while most attention is being paid to how his aggressive efforts to raise interest rates broke the back of accelerating inflation, Volcker’s interest rate hikes served another key purpose: by restoring positive costs for borrowing, they helped channel funds away from investments that produced low or even negative economic returns to society. In most of the 1980s and 1990s, as inflation fell and Congress reduced marginal tax rates, the economy began a period of significant productivity growth.

Volcker’s experience serves as an important reminder that monetary and fiscal or tax policy can do more than provide stimulus and at times help avoid recession. These policies often subsidize investors who use borrowed dollars and may distort investment incentives. In particular, monetary policy can lower borrowing costs (and lower interest rates can disadvantage savers), while tax policy can encourage leverage and discourage equity investment by allowing borrowers to deduct from their income more than the real cost of interest payments.

Here’s a simple example of how monetary and tax policy work in combination:  Imagine a world where the interest rate is equal to the inflation rate. The real or inflation-adjusted interest cost for borrowing is then zero, yet the borrower gets to deduct full nominal interest costs, so the after-tax real cost of borrowing would be negative. (Technically, net after-tax, after-inflation borrowing costs become negative when the interest rate is less than the inflation rate divided by one minus the tax rate.)

Such was the case in the late 1970s and early 1980s, when top corporate income tax rates and top individual tax rates on capital income were about 50 percent and annual inflation exceeded 10 percent. Approximately speaking, if a corporation borrowed at 20-percent nominal interest rate and took a tax deduction at a 50 percent tax rate and adjusted for inflation, its real after-tax interest rate would be below zero. Since interest rates faced by actual corporate borrowers were often well below 20 percent, tax shelters of all sorts proliferated. Investments in unproductive capital became profitable. Stagnation then accompanied high inflation during those years, as I described in a book on the topic. Whatever cash flow problems Volcker’s interest rate policies temporarily caused to businesses and individuals, they also forced investors to rethink investments in tax shelters and to make productive investments that would earn positive real private returns.

What about today?  Even though inflation remains low, businesses still get a tax subsidy for borrowing. If the annual inflation rate is 2 percent and a corporation’s borrowing cost is 4 percent, for instance, the corporation still can deduct twice its real interest costs. But in this example, corporate income tax rates would have to be above 50 percent for the real after-tax borrowing cost for the firm to be negative. However, in some foreign countries, nominal interest rates have turned negative, while in the U.S. the federal funds rate—the cost of borrowing by banks—is much closer to zero, after inflation. This means that some borrowers already may be facing negative real interest rates.

As for today’s tax policy, whatever its defects, the Tax Cut and Jobs Act (TCJA) sharply cut corporate income tax rates and effectively reduced the tax subsidy for corporate borrowing.

This feature strengthens monetary policy. If inflation accelerates in the future, the Fed won’t need to increase interest rates as much to dampen that inflation because the real after-tax cost of borrowing will remain positive. Volcker’s interest rate adjustments, for instance, could have been smaller and achieved much the same results had tax rates then been lower in the late 1970s.

That doesn’t mean that the U.S. has completely removed distortions created by our tax and financial systems. Under TCJA, borrowing by noncorporate businesses remains more subsidized than for corporations (because top individual income tax rates are higher than the corporate income tax rate). This means that the noncorporate share of business borrowing is likely to rise as the corporate share falls, all other things being equal.

Of course, high corporate tax rates and low real interest rates are not the only ways that government policies encourage excessive borrowing. Bankruptcy law protects individuals and business owners from bearing the full costs of their mistakes, not only for all assets they own, but often for each individual business. Banking laws, deposit guarantees, and implicit promises to limit bank failures further protect banks and their borrowers, while encouraging leverage. In combination with today’s low interest rates, these various policies help create negative expected real interest costs for many borrowers.

Thus, while some of these policies may encourage investment and capital formation and help the economy grow, over the long run they still can fuel excess leverage, consolidation of industries, tax sheltering, and (still) too big-to-fail banks.

Bottom line: despite lower rates of inflation today, we need to take seriously the public finance lessons from the Volcker era. While recent corporate tax rate cuts will reduce subsidies for borrowing and have some significant positive impacts on corporate finance, the nation’s borrowing juggernaut will remain well fueled and continue to weaken future economic growth by encouraging investments with low or negative real private economic returns.

This column first appeared on TaxVox on December 16, 2019.