Tax has – unusually – taken a bit of a back seat recently. In the debates surrounding the credit crunch, issues like regulation, corporate governance and executive pay have taken centre stage.

But the International Monetary Fund (IMF) put out an interesting paper last month that sought to put tax back on its usual perch. The IMF argued that tax policies had helped to create the credit boom that had preceded the crash.

How so? Tax regimes encouraged companies to seek finance via debt (against which interest payments could be deducted) than equity (where they couldn’t) and made it cheaper for individuals to take on large mortgages. The combination contributed to the unsustainable build-up of credit, the results of which we see in most countries. Not only private equity companies engineering huge leveraged buy-outs gained – the IMF argues that others too were pushed towards debt financing by the tax rules.

So what is the solution? The immediate issue could be addessed either by removing the deductibility of interest payments – politically difficult – or creating an ersatz deductibility for the notional costs of equity financing. The latter course of action would also have the beneficial side-effect of encouraging banks to hold more capital reserves. Probably more likely.

But the real underlying issue is one of tax neutrality. Distortions in the system, whereby one economic activity is effectively favoured over another, inevitably create such problems. Governments must work towards ironing out these kinks in the system and resist the temptation to ‘reward’ one group of taxpayers over another.

ACCA has recently issued a policy paper, Tax principles: from Adam Smith to Barack Obama, which spells out 12 basic tenets for a good tax system. Neutrality is crucial. At the last G20 Summit, world leaders made great play of regulators talking to each other cross-borders to learn and share best practice on regulation. They should do the same on tax.

Ian Welsh

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