The unspoken political truth about debt

Leaving aside credit creation, supported by central banks, there is no greater structural bias in favour of debt finance than corporate taxation; for much of the world, there is enormous support for the use of debt in corporations. Interest expenses on debt finance have been tax deductible for US corporations since 1918, when this allowance was introduced as a temporary measure to compensate company owners for an excess-profit tax. When the excess-profit tax was repealed in 1921, the tax deductibility of interest mysteriously remained, without explanation. The vast majority of countries around the world now operate the same system—the incentive for companies to use debt is overwhelming. Despite tax systems already being loaded in its favour, authorities further cleared the path for debt finance. In the UK, for example, advance corporation tax—a complex system that levelled the playing field for equity finance by allowing pension funds to claim tax back on dividend income, so making equity ownership more attractive—was abolished by a Labour chancellor in 1997, a process that had been started by a Conservative chancellor in 1993 as an inconspicuous way to raise tax revenue.

In the US, the BUILD (Businesses United for Interest and Loan Deductibility) Coalition, the lobbying group, is spoiling for a fight. As a few Democrat and Republican law-makers call for limits on the level of interest expenses US companies can deduct from their tax bills, BUILD senses danger, arguing that any limitation to interest deductibility would raise costs on growing businesses and stunt job growth. In practice, the tax deductibility of interest doesn’t cut costs—it just incentivises the use of debt. The original justification for the tax deductibility of interest costs, known as the debt shield, is that interest is a cost of doing business whereas equity returns reflect business income. This is nonsensical from an economic perspective; debt and equity are both sources of capital for a corporation and both are paid out of the returns to that capital. There is no reason to tax them differently.

The way pension funds work, the way savers are advised and the way regulators regulate, curtails the demand for equity. Corporate tax reduces the supply of equity.

The tax shield for interest expenses on debt subsidises the returns to equity and stops business owners having to use external equity finance which, if they did, would distribute the financial rewards of their success. One economist at the IMF thinks the evidence is clear: it creates “significant inequities, complexities and economic distortions.”

Business is not charity and entrepreneurial endeavour should be fairly rewarded. We should question, though, whether the tax deductibility of interest costs is fair. Does it compel those who own the assets to make sure they remain the only owners, even if doing so is not in everyone’s interest, including their own?

The tax shield for corporations is one of many perverse tax incentives that pervade our system. The “debt bias” is increasing the returns on equity for the few who have it, but the negative impact on the use of equity finance overall may be having a much more damaging effect. Equity’s ability to redistribute and recycle new wealth, to motivate employees and to bring valuable stability should be encouraged. Our tax systems do the opposite.

The tax deductibility of interest for corporations is the elephant-in-the-room and the debate on its legitimacy has been going on for as long as it’s been in place. The debate has been heating up. In 2005, a US presidential panel on tax reform proposed scrapping it; somewhat predictably, the proposal was rejected. Since the financial crisis, economists at both the IMF and the European Commission have proposed reform to equalise the tax treatment of equity finance; so far, however, with the exception of one or two countries, there have been few changes. In his wide-ranging review of the UK tax system, which proposed a shift in favour of equity finance, James Mirrlees, the Cambridge professor and Nobel Laureate is equally clear on the necessary changes but sees why they haven’t happened. “It is undeniable that some of the proposed changes would be politically difficult.”

There are different ways to tackle the tax bias. We could cancel the tax deductibility of interest altogether, the so-called Comprehensive Business Income Tax, or we could allow for the cost of equity finance when determining a company’s tax bill, an Allowance for Corporate Equity. Both have been researched in detail and both have pros and cons. Either way, it’s time to bite this bullet.

In the face of intense international competition for multinational companies to be headquartered in our own countries, removing the tax shield unilaterally might look like commercial suicide and, to be fair, an international treaty would be preferable. For any country, going it alone may not be as damaging as it might at first look. In 2007, US corporations, for example, paid $294bn in corporate taxes but claimed $1.37 trillion in gross interest deductions. Limiting the tax shield by 30 per cent would allow a reduction in the standard rate of corporate tax from 35 to 25 per cent while maintaining the overall tax take. Corporations in general wouldn’t be hindered, just those that use excessive debt.