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Bankers, Beware Tax Policy Changes in Fiscal Cliff Deal

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It is now mid-December and we are rapidly approaching the time when elements of the fiscal cliff (though the term "fiscal slope" is a more accurate metaphor) will move from being a future event to an immediate issue.

Much of the current debate revolves around three issues: the impact of the expiration of the Bush-era tax cuts; the concurrent potential automatic sequestration of government spending mandated by the 2011 debt ceiling approval and the combined effect of these two issues (plus a relatively large "other" category) on the U. S. economy.

Virtually every publication covering fiscal policy has dealt extensively with these issues, so an analysis of their combined impact will be unnecessary here. But it is important to call to bankers' attention several other important factors that might easily be overlooked.

Regardless of whether or not we have a tax bill, there will be fundamental changes in tax policy. History has shown, time and again, that tax incentives and penalties alter behavior. But what is less often appreciated is that these incentives and penalties are driven by government policies not necessarily based on sound economic principles, and, when policies change, the incentives can disappear, turning a great decision one year into a regretful one the next. It follows that loans based largely on tax incentives that are inconsistent with economic reality often end up being troubled or written off entirely.

Examples of the above are many, but let me recite just one.

From 1972 to 1974 I worked for an innovative, but not always successful real estate development company. At that time we were selling limited partnership interests in a number of projects, which ranged from very sound to shaky. As year-end 1973 approached, I remember being startled to note that our most shaky projects became the most attractive year-end investments. This was because their net operating losses for the year allowed for a virtual 100% write-off against income. The investors, therefore, recovered 100% of their year-end investment, had no further liability exposure and had the possibility of a considerable upside gain once the market turned.

In sum, the properties with the worst economic performance were, at that point in time, the most attractive investments. These perverse incentives ultimately got the attention of Congress and resulted in the Tax Reform Act of 1986, which eliminated the deductibility of passive losses against ordinary income. That change in tax policy fundamentally altered the value of commercial real estate properties whose valuation was subject to that tax regime. As a result, numerous banks with extensive commercial loan portfolios in the late 1980s suffered crippling losses.

Thoughtful bankers learned an important lesson. Loans made to take advantage of tax policies that distort underlying values may well become high risk loans.

That is just one of many examples of how incentives – or penalties - in the tax code generate changes in behavior. To make the point even clearer, recall the response to the 1993 tax change that capped the deductibility of corporate salaries to $1 million when not deemed "performance based." This policy effectively capped guaranteed income. But the effect was entirely negated, however, as corporations compensated by issuing equity grants that drove total executive compensation through the roof.

There are a number of current incentives in today's tax law that may be subject to change, elimination, modification or extension. Many of them involve energy policy in one way or another.

The current requirement that ethanol be used in all automobile gasoline has caused the price of corn to skyrocket, which in turn has generated increases in land values in certain agricultural areas. These values seem entirely dependent on continued government support for crop prices at levels that defy economic logic. Loans based on these values, as opposed to loans based on realistic cash flow estimates under a more normalized crop price environment, may be at risk.

Our current tax policy provides energy-related penalties for carbon emission and incentives for wind power. Predictably, investment dollars in these areas may respond accordingly.

As bankers follow the potential outcomes of the fiscal cliff debates, it is important to keep several points in mind. Most critically, the uncertainty of our current position means that many decisions involving capital investment are being postponed or eliminated. I recently heard a major bank CEO, when asked his preference on proposals to change tax policy and address deficit issues, say simply, "Just give us one. We will adjust to whatever policy is imposed, but we need to know what it is." The current lack of certainty in our nation's fiscal policy has significant economic consequences.

Second, keep in mind that tax incentives (and penalties) drive behavior regardless of whether or not the incentives represent sound economic reality. And banks will be asked to provide lending and investment support accordingly. In times of potentially significant change in government policies, it is important that lending policies and practices demonstrate more sound judgment than the policies that created the incentives.

Mark W. Olson's former positions include Federal Reserve Board Governor, Chairman of the PCAOB, Chairman of the American Bankers Association and bank President and CEO. He is co-chair of Treliant Risk Advisors LLC and can be reached at molson@treliant.com.

 

 

 

 

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