Modest Proposal to Jump Start The Credit Markets

Open any newspaper or put on any news program, you are bound to see the same or similar headlines:  The global credit system is in a state of paralysis.  Simply, those institutions that normally lend to businesses and consumers (such as banks and credit card companies) have decided a more prudent course of action is to limit or entirely cut off credit lines, bank loans, credit revolvers, home equity loans or mortgages, or refuse to purchase corporate or high yield bonds.  While the equity markets normally get all of the headlines, it is the credit markets that is the lifeblood of the economy.  It terms of size, the credit market dwarfs the equity markets.  That is why Bill Clinton was so concerned with how the bond market reacted to his policy proposals.  Therefore, if we are going to get out of this deep recession, we need to somehow stimulate the credit markets, and get lenders to lend more money to businesses and consumers.

Over the past 12 to 24 months with the stock and real estate markets crashing, many investors and financial firms are stuck with capital losses for as far as the eye can see.  A capital loss is where you invest in a stock, bond or other investment (such as real estate) and you sell it for less than you bought it for.  A capital gain is the opposite, you sell an investment asset for more than you bought it for.  The tax code gives preferential treatment to long-term capital gains (as opposed to the treatment it gives to ordinary income), taxing them at the maximum rate of 15%.  As stated above, lately most investors do not have capital gains; rather, they have capital losses.  However, a taxpayer can only offset capital losses against capital gains.  In other words, you cannot deduct any net capital loss (capital losses that exceed capital gains) against ordinary income except for $3,000 / year; you can only deduct capital losses from any capital gains.  While you can carry forward net capital losses to offset future capital gains, many people have losses so large that they will likely never be able to offset the total amount.

Unlike capital gains, interest earned on loans or bond investment is not taxed at capital gains rates.  Rather, it is taxed the same way your salary and bonus is taxed–as ordinary income at much higher rates. Therefore, if you are deciding between making a capital investment and a loan, all things being equal (namely the return on each transaction), you are better making the capital investment.  But right now, our economy is in desperate need of loans, whether they be mortgages or credit lines.

This proposal below might sound strange coming from a liberal Democrat; it is the sort of thing that you would more likely hear from the Cato Institute or the Club for Growth.  But I am not concerned with orthodoxy.

My Proposal:  For a limited period of time, allow individuals and other lenders to offset interest income with net capital losses carried forward from previous years.  This will increase the returns on loans and bond investment by increasing the value of the interest earned.  For example, if you are bank, your marginal tax rate is most likely ~35%.  By allowing the bank to offset interest income against net capital losses suffered in the past, the interest earned will be 35% more valuable.  This will incentivize lenders (whether they be banks or individuals) to make more loans, which is what the economy needs. Some of the loss in interest income taxes will be offset by increased income that results from the lending.

Update

Biggest Losers:

Municipal bond issuers.  Currently, interest paid on municipal bonds is not federally taxable and not taxed by the state that issued the bonds.  For example, if you own a California General Obligation bond, the interest paid is not counted as income on your federal or California state tax return (assuming you file a Cal. return).  This attracts investors who are in high marginal tax brackets, where this mariginal interest income is most valuable.  But if other interet income offers similar tax treatment, it will cause municipal bonds to be less attractive (and will result in municipal bond prices falling for current issues and future issues to pay higher interest rates).

Municipal bond holders:  If other investments get similar tax treatments, this will result in less demand for municipal bonds.  Less demand will result in lower prices.

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