Series: The Trade Hold Companies, Executives and Government Officials Accountable

Thanks to a leaked video, we know that Mitt Romney divides the country into those who pay taxes and those who don't, the makers and the moochers.

There is one perhaps surprising group you can put in the latter category: the nation's banks. Sure, banks pay taxes, but they pay a lot less thanks to a giant and underappreciated distortion in our nation's tax code. Moreover, this tax code distortion makes the financial system and the economy more fragile, prone to bankruptcies and runs. Banks profit, and the economy teeters. Great bargain, huh?

It's the tax code's favoring of debt over equity.

For businesses, debt interest payments are tax deductible; equity payments, like when a company pays out a dividend, are not. At the margin, this encourages entities to take on more debt than they otherwise would, as Steven M. Davidoff noted in a Deal Professor column earlier this year. More debt not only makes companies more vulnerable to bankruptcy but also makes investors more susceptible to panics, when they withdraw their capital en masse. More equity would make the world more stable.

"The worst thing the tax code can do," says Victor Fleischer, a tax specialist at the University of Colorado, "is to make it harder to use a sensible capital structure." Mr. Fleisher, a contributor to The New York Times DealBook, testified in front of Congress last year about this problem.

This distortion is well known. President Obama, in his tax reform proposal, mentioned it, though he didn't make any specific proposal about what to do about it. The Republican candidate, Mitt Romney, is proposing substantial tax cuts with the loss of revenue made up with the closing of loopholes. He has yet to specify any of those loopholes, but corporate debt interest deductibility hasn't been in the conversation.

What isn't well appreciated is how much the debt deduction helps the banks. The first way is direct: Banking is a highly leveraged industry. Banks use more debt than equity to finance their activities. The tax break makes the debt cheaper and encourages banks, at the margin, to gorge on more.

Financing techniques that have become more popular in recent decades benefit from this distortion. Bundling of debt, like credit card receivables or mortgage debt, called securitization, turns out to give banks a tax bonanza. For accounting purposes, banks are typically able to treat their bundling of this debt as a sale. But for tax purposes, banks often get to call it debt. Those payments to the buyers of the securitizations' bonds are therefore tax deductible to the bank.

More important, there's an indirect and unremarked benefit. Banks help companies raise money in two main ways: through the sale of stock (equity) and debt, either through loans or the sale of bonds. When a company goes public, selling stock for the first time, the underwriting banks make more money than they do for a comparable debt offering. But banks make it up on volume with debt. Bonds expire. Companies issue more of them all the time.

Partly because of the tax code distortion, corporate debt is underpriced and overconsumed by the bank's corporate customers. Indeed, the debt business dominates the world of investment banking these days. When corporations raise more debt compared with equity, that fattens bank profits.

Then, too, the trading of debt is more profitable than the trading of equity. Stocks are traded on transparent markets at transparent prices. Debt is traded in opaque ways, where the spread between the offered and requested prices is wider than for stocks. That means more profit for investment banks compared with stocks, whose trading spreads have narrowed for decades. So, too, with derivatives and securities based on debt — things like collateralized loan obligations.

And these complex debt securities give society — what? The system we have subsidizes the middleman to create dubious products. Those products help the middlemen — the banks — but they make the financial system more fragile. So the tax code distortion doesn't just lead to more debt in corporate America and more leveraged banks. It also helps create a finance-heavy economy where the banking sector accounts for a bigger proportion of gross domestic product and corporate profits than it otherwise would. Granted, the tax code is far from the only force in American society that creates a larger financial sector or overleveraged corporations. But it's one of the least recognized.

As most of us have come to understand since the financial crisis, having a bigger finance industry than necessary wastes resources. Banking is supposed to provide capital to help companies create real goods and services, not be an end unto itself.

As it is, lawyers, accountants and investment bankers spend thousands of billable hours analyzing transactions to figure out if there are ways to treat them like debt, rather than equity.

Are there solutions to this distortion?

There are two choices: reduce or eliminate interest deductibility or introduce some deduction for equity.

Neither seems particularly feasible for some time. Reducing the deductibility would be elegant but generate screams of bloody murder from corporate America.

Making dividend payments tax deductible, which would start to level the playing field, might be easier and more popular. Of course, that would reduce revenue to the government and have to be made up somehow, though tax increases elsewhere or decreased services.

Mr. Fleischer suggests that one way to limit the distortion would be to eliminate the deduction to the extent a financial institution exceeds a ratio of debt-to-equity of 5 to 1. If a bank has borrowed $6 for every $1 in stock, then it doesn't get to deduct the interest payments on that extra dollar of debt. That would make debt more expensive and make banks less inclined to borrow as much.

And it would help stop banks from being moochers.