Guest Post: The Tax Code ENCOURAGES Leverage

Among the most prophetic voices prior to the economic crash was UCLA economics professor Harold H. Somers, who warned in 1991 that revisions to the tax code would increase leverage, which could lead to economic disaster:

The result is to tilt the well-worn playing field even more in favor of leveraging, leading to the possibility of another leverage frenzy and debacle at some time in the future.

Professor Sommers explained:

The complete history of the causes of the junk bond debacle of 1989 and 1990 is yet to be written. But the tax incentive must have a prominent place in any comprehensive work. This comment applies to long-term debt where the interest deduction can be a major factor; short-term debt may be dominated by other considerations.

What is involved is essentially the shield against income tax that is provided by corporate debt compared with the shields that are provided for equity by the income tax rules …

Former President of the St. Louis Federal reserve Bank – William Poole – agrees in a new paper:

A straightforward fix for excessive leverage can be achieved through the tax system. Companies borrow, in part, because they believe that debt capital is cheaper than equity capital. That is certainly the case under the U.S. corporate tax system because interest is a deductible business expense in calculating income subject to tax whereas dividends are not deductible.

Excessive leverage is highly destabilizing to the financial system (see this, for example). If a simple fix to the tax code could substantially reduce leverage, I’m all for it.

Poole recommends the gradual phasing-in of changes to the tax code to reduce leverage:

Interest deductibility could be phased out over the next 10 years. Next year, 90 percent of interest would be deductible; the following year, 80 percent would be deductible, and so forth, until interest would no longer be deductible at all. The same reform would apply to all business entities; partnerships, for example, should not be able to deduct interest if corporations cannot.With this simple change, the federal government would encourage businesses and households to become less leveraged. We have learned that leverage makes not only individual companies more vulnerable to failure but also the economy less stable. We use tax laws all the time to promote socially desirable behavior; eliminating the deductibility of interest would reduce the risk of failure of large companies—especially, large firms—and thereby reduce the collateral damage inflicted by such failures.

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8 comments

  1. Ultimate Janitor

    The bankers have infiltrated every aspect of government with their “infuence”. Why would the tax code be any different?

    This is a “horse has left the barn” issue at this point.

    Fooling with deductibility of interest, accelerated depreciation and non-income taxes right now would create an even bigger disaster than the one we are currently experiencing.

    I agree that there should be some sort of phase out of certain deductions over time.

  2. ZZ

    Interest is deductible because the income tax is a tax on _net income_. Net income = gross income minus expenses, including business interest. If you gross $100k but spend $100k to pay off suppliers, employees, and lenders, the net income is $0 and the proper tax is $0. The lenders pay income tax on the net interest income they receive.

    The correct fix for the debt-equity disparity is to make dividend payments tax-deductible too, eliminating the double taxation penalty for using equity. It would also remove the disincentive of using C corporations, which would then be taxed at a single level just like partnerships, sole proprietorships, and S corporations. But such a fix is too logical and too easy.

  3. Peter T

    ZZ:
    > Interest is deductible because the income tax is a tax on _net income_. Net income = gross income minus expenses,

    It depends on the kind of expenses. Once upon a time, bribes to foreign public officials were tax deductible, now they are not. I don’t see a legal problem in phasing out interest deduction, only a political one. It’s about time to change the tax code.

  4. Elvin

    I agree that interest deductibility increased leverage. I’d like to see much, much higher dividends paid, especially at investment banks. Shareholders have taken too much risk with these banks. By forcing management to pay more in dividends, the capital at risk is reduced. I’d like to have bankers complaining about restricted growth because of greedy shareholders.

  5. Doug Terpstra

    According to WikiAnswers.com in 2006, there were over 16,800 pages in our tax code, and according to the Center for American Progress that translates into 61,000 pages of federal tax rules, including tax code, regu-
    lations, and IRS rulings. I don’t suppose (m)any of those are written for the general welfare, do you? (http://www.americanprogress.org/kf/sbctestimony.pdf)

    Not bad work for 2,370 financial services lobbyists—equivlent to 4+ aides for each legislator in the kleptocracy. (http://www.politico.com/news/stories/1009/28439.html)

  6. charcad

    Poole’s paper is more accessible here:

    http://www.cato.org/pubs/journal/cj29n1/cj29n1-15.pdf

    This was amusing.

    Before I dig into this subject further, I want to make clear that my perspective on the source of the financial crisis is that the crisis was fundamentally caused by mistakes in the private sector—mistakes in private financial firms—and not by mistakes of the federal government.

    I remember reading William F. Buckley commenting on the different tax treatments given to dividends (equity) and interest (debt) back in the 1970s when I was in college the first time. It’s not a new observation.

    In general I’m all in favor of encouraging an ownership society by all means possible, as opposed to the usury debt slavery society we now have.

    I’ll be interested to hear Yves’ take on this.

    It seems to me Poole is focusing exclusively on the demand (“borrowers”) side. There’s a supply side (“lenders” and “equity investors”) that Poole isn’t addressing.

    Companies borrow, in part, because they believe that debt capital is cheaper than equity capital.

    They believe this because it’s almost always been true. And this is not just because of more favorable treatment for interest versus dividends in tax law. Debt has preferential treatment over Equity in bankruptcy law, too. This lowers the risk of Debt investments and therefore the returns that lenders must seek.

    “Equity” has to seek higher returns because the risk of this investment form is far greater. For example, look at what happened earlier this year to GM’s common shareholders compared to GM’s lenders.

    Removing the tax deductibility of interest payments by itself seems insufficient to change the dynamics enough. The relative Risk between Debt and Equity will remain unaltered.

    In my opinion the largest effect of Poole’s proposal by itself would be to increase effective taxes on corporations and thus raise the cost of corporate capital overall.

    We also have to look at the primary metric by which officers of publicly listed companies are presently graded. This is Earnings Per Share. This number grows larger when Earnings are divided by ever fewer Shares. As a result it’s routine to see companies conduct share buyback programs even though they have large amounts of outstanding bank loan and bond debt.

    1. vlade

      I keep arguing that there’s no real difference between debt and equity.
      Preferred shares can have higher claim on assets than some junior debt (not even talking about debt issued by an SPV). It also (often) pays fixed coupon and cannot vote. On the other side, debt covenants and lenders in general can influence the company decisions more than shareholders – and often do.
      If there are no assets in the company, no-one gets paid regardless of whether they are debt or equity holders.

  7. thoughtbasket

    Whether achieved by phasing out interest deductions or matching them with deductions on dividends, is there an economic argument in support of differential tax treatment of debt and equity?

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