Bad Debt Deduction = Good Tax Policy

In her post below on the Mortgage Forgiveness Debt Relief Act of 2007, Marie wonders why the revenue loss wasn’t paid for by denying the bad debt deduction to the lenders for debt forgiveness excluded under the Act.

There are several good reasons why that would have been a very bad idea. First, a primary goal of our tax system is to measure (and tax) net income. These lenders have lost real money on these transactions and thus general tax policy supports the allowance of deduction for that loss. Denying the deduction as a stick to penalize the lenders further is not an appropriate use of our tax system.

There are instances where we have determined other policy goals trump a more accurate measurement of net income (for example, the general realization requirement). Perhaps this is another one of those situations, the policy of penalizing the “bad” lenders trumps allowing a deduction for money that is truly lost. In the end, this argument does not hold up. First, we know that not every lender out there holding the subprime bag engaged in deceitful practices so the penalty would be overbroad. Second, many lenders don’t even hold the loans anymore. They were sold to someone else who had no connection to the original loan. Unless we want to say that we should penalize people for even investing in this market, the denial of the deduction would not be affecting the “bad” people. Personally, I wouldn’t deny the deduction for anyone (even if we know they engaged in deceitful behavior) since again I don't believe the tax system is the appropriate tool for that but an overbroad denial would penalize many people with no connection whatsoever to the practices that many are now complaining about.

Another reason that denial of the deduction is bad policy is it would discourage lenders (or those who hold the debt) from forgiving the loans. Marie could probably tell us why there are still reasons why it would still be good for lenders to get bad loans off the books even if they would not get a bad debt deduction, but it is clear that a lender is more willing to forgive debt knowing that they will get a tax deduction.