Why the debt-versus-equity bias is hard to dislodge

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JIT MAKES US corporate finance rarely attract the attention of activists. It is even rarer that those at both ends of the political spectrum agree on the need for change. However, when it comes to the tax system’s preferential treatment for debt over equity, the left-leaning Tax Justice Network and the tax-conservative Tax Foundation agree that the “debt bias” needs to be corrected. . But the degree of consensus belies the difficulty of doing so.

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Most countries that levy corporate income taxes treat debt more favorably than equity, largely because they allow interest payments, like other costs, to be deducted from tax bills. This gives companies a huge incentive to borrow, rather than finance themselves with equity. In the United States, Britain, Germany and Japan, debt financing is taxed at rates 3.8 to 6 percentage points lower than equity investments, depending on the OECD. The result is more indebtedness than would otherwise have been the case. According to the Securities Industry and Financial Markets Association, the value of outstanding debt securities is $123 billion, exceeding the $106 billion of listed stocks worldwide. the IMF estimated in 2016 that debt bias explained up to 20% of total investment bank leverage.

The bias affects a large number of companies, from small unlisted family businesses to the largest public companies in the world; and higher indebtedness in general exposes them more to economic shocks. But because the problems faced by highly leveraged lenders can easily upend the rest of the financial system, researchers have tended to focus on the effects on banks. Total revenues are often small compared to the large flows of interest payments made to and from lenders, and the removal of interest tax deductibility could make some of them unprofitable.

The debt bias increases as corporate taxes rise, posing headaches for governments hoping to shake up profitable companies to plug tax holes. It has therefore not gone unnoticed by the authorities, although recent attempts at rebalancing have been marginal. A rule that took effect this year in the United States limits the tax deductibility of debt interest to 30% of a company’s earnings before interest and taxes, as part of President Donald Trump’s 2017 tax reforms. the EU is considering a “debt-to-equity bias reduction allowance” , the details of which have not yet been made public.

What would comprehensive reform look like? In an article published in 2017, Mark Roe of Harvard Law School and Michael Tröge of ESCP Business School came up with some ideas. One is to treat debt less preferentially. They imagine a bank with $50 billion in gross profits and $40 billion in interest payments. With a full interest deduction and a 20% corporate tax rate, the bank would pay $2 billion in tax and have the incentive to go into debt. But if the interest deduction were completely eliminated, a 20% tax rate would wipe out the bank’s entire net profit. One solution would be to remove the deductibility, but lower the tax on gross profits. A 7% rate in this scenario would bring as much in the tax department and place the same burden on the bank as a 35% tax on net profits.

Another option, which may be more politically viable than lowering tax rates, is to make issuing shares more attractive. The researchers propose a version of an allowance for business equity (AS), which would make some of a bank’s equity – beyond its regulatory requirements – as tax-advantageous as the debt. If a bank had $100 billion in capital above what it was required to issue, a 5% deduction would reduce its taxable profit by $5 billion, in the same way as $100 billion of debt with an interest rate of 5% would be treated. The principle could just as well apply to non-financial companies.

Indeed, some European countries, such as Italy and Malta, have introduced AS schemes for a wider set of companies. the OECD estimates that Italy’s tax bias in favor of debt is now less than one percentage point. The European Commission finds that the country’s system has reduced the debt ratio of manufacturers by nine percentage points, with a greater effect on small businesses.

Reducing the bias is therefore not impossible. But it will be much more difficult to determine whether the reform will upset the vast edifice of debt financing, particularly in the major markets of America or the rest of the world. EU. (The Italian regime only covers newly issued stocks for this reason.) The preference for debt is entrenched enough that its elimination could have significant and lasting effects on portfolios around the world. Serious change may not happen as quickly as activists hope.

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This article appeared in the Finance and Economics section of the print edition under the headline “Conflict of Interest”

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