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Should We Quit Subsidizing Corporate Debt?

The White House released its plan for reforming taxes on business last week.

The23-page document is long on diagnosing the problems with the way we currently tax business, but falls short when it comes to details about the administration’s proposed cures. The tax rate would be lowered and tax breaks would be eliminated—although which ones aren’t specified.

One tax break that is singled out by the report is the deduction for interest payments on the debt of businesses.

The current corporate tax code encourages corporations to finance themselves with debt rather than with equity. Specifically, under the current tax code, corporate dividends are not deductible from corporate taxable income, but interest payments are. This disparity creates a sizable wedge in the effective tax rates applied to returns from investments financed with equity versus debt. Profits generated by an equity-financed investment will be taxed at the 35 percent corporate rate, leaving 65 percent of the profits for dividend payments to shareholders. In contrast, profits from the same investment funded by debt will only be taxed to the extent they exceed the associated interest payments. Once the deductibility of interest is combined with accelerated depreciation, the cost of debt capital declines even further. In fact, on average, debt-financed investments are subsidized (i.e., their effective marginal tax rate is negative), as income generated by such investments is more than offset by deductions for interest and accelerated depreciation.

This subsidy for indebtedness has to be one of the most loathed aspects of the tax code. A panel convened by the Bush administration recommended getting rid of it in 2005. Paul Volcker recommended ditching it in 2009. So did James Surowieki of the New Yorker. Felix Salmon wants it eliminated.

The problem, as almost everyone sees it, is that because debt is subsidized, companies take on too much debt on too little equity. This additional leverage leaves them more vulnerable during economic downturns.

Let’s quote the administration’s report:

This tax preference for debt financing has important macroeconomic consequences. First and foremost, outsized reliance on debt financing can increase the risk of financial distress and thus raise the likelihood of bankruptcy. Unlike equity financing, which can flexibly absorb corporate losses, debt and the associated contractual covenants require ongoing payments of interest and principal and allow creditors to force a firm into bankruptcy. A solvent firm with limited liquidity that is struggling to make its debt payments may experience losses of customers, suppliers, and employees. It may engage in destructive asset “fire sales” and forgo economically profitable investments. And, in an attempt to avoid bankruptcy, levered firms faced with financial distress may resort to high?risk negative economic value investments. In the broader context, a large bias towards debt financing in the corporate tax code may lead to greater aggregate leverage and the associated firm?level and macroeconomic costs of debt financing.

The administration then produces a chart, which you can find on page 6 of the report, showing that the difference between the marginal tax rate on equity and that on debt for the U.S. is far greater than any other developed country. Only France comes close to meeting our tax preference for debt.

Now I’m typically against tax preferences of almost all sorts, largely because I think market processes are better at producing prosperity than government plans. But there’s another good old rule that we should probably at least consider here—never knock down a wall until you’ve at least figured out why it was put up in the first place. In the case of the tax preference for debt, we should at least try to figure out if there is any benefit at all.

Surowieki writes that the “social benefits” of the debt subsidy are “pretty much non-existent” or “illusory.” But that’s not quite true.

Last year, Zhiguo He and Gregor Matvos, of the University of Chicago’s Booth School, published this paper arguing that the debt preference has “positive externalities”—that is, the social benefits are actually existent and non-illusory.

The main social benefit they find is that an increased debt load can force a failing company to shut down earlier than it would have otherwise. This is socially beneficial because it results in the redistribution of the resources of the company—its capital, its physical plant, its employees—to more efficient uses.

“Such liquidation redeploys assets to alternative firms and sectors, and stops inefficient further investment. This reallocation can be especially important when economies are transitioning from demand and technological innovation shocks, which render some industries obsolete and at overcapacity,” He and Matvos write.

In other word, the debt preference helps along the process of creative destruction.

Another possible social benefit that I’d argue is implied in He and Matvos’s work comes from the amelioration of agency costs. Managers of firms, knowing that they stand to lose their positions in a bankruptcy, may take on too little debt than is optimal from a shareholder’s point of view. They may have a preference for excess equity to absorb the losses and conceal mismanagement. The debt preference in the tax code increases the costs to managers who attempt to exploit shareholders in this way.

Finally, there’s a third broad social benefit at work here. We know from basic financial economics that capital structure—that is, the mix of debt and equity—doesn’t matter when it comes to returns. A dollar borrowed performs just as well as a dollar purchased with equity. So when you have a tax preference for debt, you get more debt than you would otherwise.

By encouraging the issuance of debt at the corporate level, the tax preference may be generating opportunities for household sector savings. That is, to the extent that households desire the kind of fixed-income savings generated by highly rated corporate debt, the tax preference aides households in acquiring this type of savings. It makes these savings vehicles cheaper for households—that is, more expensive for corporations—by increasing the supply.

I’m still not convinced that the preference is a good idea. But it’s been around for quite a while and a century of American prosperity was built with it in place. I think we’d better do some hard thinking about what good it might do before we knock it down.

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