For 100 years now, capitalism has had a pro-leverage bias. Unlike dividends, which are paid only after the state has taken its share of earnings, interest is deducted from pretax profit, shrinking the pie available to the government.
This accounting oddity, which treats debt capital more favorably than equity, has driven the leveraged buyout industry, led to a correction in a foundational paper by a pair of Nobel economics winners, and played a role in the 2008 financial crisis. Disaffection with this anomaly has long swirled as an undercurrent, especially in tax-starved developing economies. The coronavirus is reheating the debate.
Industrial losses may need to be socialized en masse to get displaced workers back on the job and prevent the global economy from spiraling into depression. To manage the backlash against using public money for private gains, more countries are likely to follow the U.S. Congress and the U.K. banking regulator, which have pushed for a halt to buybacks and dividends. But corporate rescue this time may also involve a rewriting of accounting rules to encourage deleveraging, so that bailouts are needed less often and are less costly.
It was in 1918, when economists were likening the global spread of an excess profit tax on wartime corporate income to the deadly outbreak of the Spanish flu, that the U.S. relented and allowed all interest paid to be deducted from taxable profit. It was a temporary measure to give firms relief, but although the extra tax burden went away in 1921, the favorable treatment of interest income stayed and was copied around the world.
The debt bias is very real. In the late 1950s, academics Franco Modigliani and Merton Miller controversially asserted that corporations should be indifferent to the mix of debt and equity in their capital structure. Five years later, the professors issued a correction, acknowledging that a dollar of debt would raise the value of a firm by 50 cents, the then-prevailing corporate tax rate.
The idea of a withholding tax on interest payments has done the rounds since at least 1982, but how does a foreign investor or a tax-exempt local investor get credit? No country would want foreigners to shun its corporate debt and go where there’s no withholding. Developing economies have also been ambivalent. Their tax authorities hate it when multinationals give loans to their profitable subsidiaries, thus reducing their taxable income in poor nations.
On the other hand, it didn’t take long for local firms in Asia, Latin America or Eastern Europe to figure out that they, too, could attract large pools of Western savings by souping up shareholder returns with higher leverage. It helped that the cost of the debt was tax deductible. To the extent the borrowings came from state-owned local banks, the lenders’ interest income flowed to the government as taxes and dividends.
After the 2008 crisis, policymakers looked aghast at the debt-financed expansion in banking over the previous three decades. But beyond specifying higher regulatory capital, they couldn’t do much to shake the inertia. As McKinsey & Co. noted in 2010, replacing the stock of financial sector debt with equity in just 14 countries would have required more than 60% of the then-existing global equity capital.
No wonder, then, that the world economy has kept accumulating debt. China stepped up borrowings to hold on to high growth in a slow-speed world; India wrecked its finance industry to achieve China-like expansion. On the supply side, as banks retreated under regulatory pressure for more capital, private credit from insurers, pension funds and other non-banks took their place, growing to a $300 billion industry by 2018 from $100 billion in 2010.
The additional corporate value garnered with cheap debt isn’t a free lunch. An International Monetary Fund staff discussion note warned in 2011 that “costs to public welfare are larger — possibly much larger — than previously thought.” The 2017 overhaul of the U.S. tax code restricted interest deduction to 30% of earnings before interest, tax, depreciation and amortization as an offset for slashing the corporate rate to 21% from 35%. The U.K., too, put a limit.
But then came the coronavirus. The sheer scale of economic disruption and job losses means that governments and central banks will join hands. Japan’s near-$1 trillion fiscal spending has set the tone for outsize government borrowing. But while assuming a more active economic role, governments will also want to show that they aren’t running a Ponzi scheme. Disallowing interest deduction will generate resources as well as play into the zeitgeist for more public welfare.
As independent strategist Gerard Minack noted recently, our world is primed to maximize financial returns on the assumption that nothing will go wrong. When things do, not just once but twice in 12 years, politicians must ask whether a smaller, more resilient firm, valued a little less than before, is better than a large but fragile enterprise. Minack also believes that temporary restrictions on stock buybacks could be accompanied by changes to the tax treatment of debt.
With industries of all hues begging governments for survival capital, rebates and even employee wages, bargaining power of firms is at rock bottom. The unfinished tax reform agenda has a chance. Given that suppliers of debt financing are spread all over the world, a withholding tax on interest payments could cause dislocations. “A less disruptive option,” as law professors Michael Graetz and Alvin Warren, Jr. argued in a 2016 essay, “might be to deny deductions for all or part of interest payments at the corporate level.”
Overcoming entrenched resistance to a once-in-100-years change won’t be easy. The only time to even attempt it is when faced with a disaster not encountered since the Spanish flu. -Bloomberg