Encouraging companies to gear up is barmy. Yet, that’s the effect of allowing interest payments to be deducted from profits before tax bills are calculated. The tax advantage makes borrowing more tempting for companies.
That allure has helped bring the world to the brink of crises in leveraged buyouts and commercial real estate. Many companies will go bust and banks will suffer bigger losses – making the recession deeper than it needed to be.
The tax deductibility of corporate interest costs is a long-standing tradition in most countries. In the US, it was part of the first taxes on profits, in 1894. The spurious justification is that interest is a business expense like any other. But it is better to consider all debt as a type of capital, like equity. The difference is that the payments made by companies to service their debt are tax deductible – whereas dividends generally are not.
Companies, therefore, have an incentive to pile on debt and reduce their equity. They are only restrained by the fear that when business turns down, the money won’t be there to make interest payments.
In the boom those fears melted away and the cult of “financial efficiency” took hold. The tax deductibility only added to the appeal of low interest rates. There was super-high leverage in two areas LBOs and commercial real estate, while some ordinary companies levered up by borrowing to buy back shares. Then there were debt-financed acquisition sprees.
All this taxpayer-financed speculation created bubbles which have now burst. Losses on corporate and commercial real estate loans originated by US financial institutions alone will reach $829bn in this cycle, according to RGE Monitor, a research firm. To this should be added mark-to-market losses on corporate debt and commercial real estate securities, which were $745bn in December.
There have been a few efforts to cut the tax advantages for the most highly leveraged companies. The current crisis offers an opportunity for more general reform. Governments should phase out the tax-deductibility of interest payments, so that taxes are paid on operating profits. To make the effect on businesses as a whole neutral, corporate tax rates should be cut.
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Of course, in a world without tax subsidies for debt, LBOs and highly leveraged organisations will pay more tax. The private equity industry would howl in protest at the prospect. They should be ignored.
It may be possible to get an international consensus. The zeitgeist is changing. G20 countries have already come together to crack down on tax havens. Why not try to do the same for debt-driven financial engineering?