

Tax-Free Debt: The great distortion - jessaustin
http://www.economist.com/news/leaders/21651213-subsidies-make-borrowing-irresistible-need-be-phased-out-great-distortion

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sksk
I would recommend that people actually read the referenced Economist articles
instead of the blog:
[http://www.economist.com/news/leaders/21651213-subsidies-
mak...](http://www.economist.com/news/leaders/21651213-subsidies-make-
borrowing-irresistible-need-be-phased-out-great-distortion) and
[http://www.economist.com/news/briefing/21651220-most-
western...](http://www.economist.com/news/briefing/21651220-most-western-
economies-sweeten-cost-borrowing-bad-idea-senseless-subsidy)

For those who don't have the patience to read more on this topic, the key
argument is that debt creates perverse incentives. If you follow Basel II or
III regulations, you will know how hard it has been for the regulators to
convince the banks to increase their tier-1 capital. The banks are happy to
pile on more debt rather than raise more equity capital (the purest form of
capital) as debt is cheaper and comes with nice tax benefits. The financial
crisis of 2008 was exacerbated because of leverage (another way of saying lots
of debt).

While this can certainly reduce leverage in the banking sector, the author
raises the question of start-ups vs. big companies. Big companies have massive
balance sheets and will generally be able to borrow at much better rates
whether or not there is tax incentive. If an up and coming start-up is
amazing, I am sure there will be 100s of equity investors who will be willing
to throw money at it. I wouldn't worry about this impacting them.

That said, this will not fly in the US. So much for logical reasoning.

~~~
cm2187
Banks are the only industry where tax deductibility actually makes sense,
because a bank is essentially a wholesale broker of debt. You lend to the bank
with your current and saving account, it lends to the economy. Tax
deductibility will not really result in the bank leveraging less, as the bank
is not the ultimate payer of the interest. It will only make it more expensive
to borrow from a bank. And the tax will be paid twice (first by the bank, then
by the ultimate payer of the interest).

~~~
XorNot
"Double taxation" is a fallacious argument, concocted by lobbyists for the
rich to complain about the taxes that impact them personally.

This comic summarizes it perfectly:
[http://i.imgur.com/Lw61YGs.gif](http://i.imgur.com/Lw61YGs.gif)

~~~
rahimnathwani
I'm not sure I understand your point.

Let's say I run a lemonade stand as an individual, and this year the stand
makes a profit of $100,000. Let's say individual income tax is 30%. I'd pay
$30,000 tax, right? So I'd be left with $70,000 in my pocket.

What if I had decided to set up the lemonade stand as a corporation instead?
The corporation would pay some sort of profits tax (say 20%, so $20,000).
There's now only $80,000 for me. But I have to pay personal tax of 30% of the
$80k, so in this scenario I walk away with only $56k.

Why should the total tax take in the two scenarios be different?

How could I change the second scenario, to preserve the corporate structure,
but maximise the money in my pocket?

~~~
EliRivers
_Why should the total tax take in the two scenarios be different?_

Why _shouldn 't_ they? They are two different situations. Different situations
can lead to different outcomes.

~~~
rahimnathwani
The two situations are economically identical. The economic activity is the
same. The same amount of profit has been made in each case.

EDIT: Yes, I realise that corporations have specific legal
attributes/benefits. However, taxing their profits twice doesn't seem (i)
fair, or (ii) likely to provide good incentives.

~~~
EliRivers
A corporation is not just a label. A corporation carries a number of legal
obligations and protections. If you want those legal obligations and
protections, you pay the price for having them. If you don't want them, don't
become a corporation.

The fact that the situation appears economically identical is irrelevant, and
actually they're not economically identical. Doing business with a corporation
is very different to doing business with an individual, because of those
obligations and protections.

As another contrived example, stealing ten dollars from someone is
economically identical to having that person gift you ten dollars, but they're
not remotely the same thing.

~~~
rahimnathwani
You are right that we must pay the price for any legal protections afforded to
corporations. I agree that, today, double taxation is part of that price.
However, I believe that double taxation should _not_ be part of that price.
The two examples I gave should be taxed in the same way. Sure, the corporation
scenario may have some additional administration and filing fees, but I don't
believe the poor shareholder should pay almost twice as much tax, just to get
the protections afforded by a limited liability structure.

You are right that the situations are not economically identical. That was not
a useful over-simplification on my part.

~~~
XorNot
Someone drinks your lemonade and has a heartattack. The family sues the
corporation and wins millions. However your corporation is a limited-liability
entity and so files for bankruptcy.

Your personal income and savings, paid as wages, are immune to bankruptcy
proceedings. The corporation loses its cash and holdings, but you don't lose
your house.

This is a staggering fiscal and economic advantage. You absolutely should be
paying _a lot_ for it given the net effect on everyone else.

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Animats
It's significant that The Economist is endorsing this concept. It may now go
mainstream.

This is more of an issue for businesses than for individuals. Businesses get
to choose how they obtain capital, and that decision is often driven by tax
considerations. All the ways companies pay for capital - interest, dividends,
and stock buybacks - should be taxed at the same rate. Right now, there's a
huge tax bias in favor of debt. Borrowing for stock buybacks is a huge
fraction of US corporate borrowing, and it's driven by tax considerations.
That's effectively a very expensive subsidy program.

Eliminating the tax benefits of debt has systemic advantages. When a company
financed by equity goes under, its stockholders suffer, but the potential loss
is bounded. As we learned in 2008, debt-financed failures cascade. Much M&A,
private equity, and hedge fund activity is fuelled by the tax advantages of
equity to debt conversion. Eliminate those, and much unnecessary financial
activity goes away. The hedge fund industry will scream, but now that it's
well known that hedge funds underperform the market while extracting huge
fees, that's no big loss.

This change shouldn't affect startup companies. Those are almost always equity
funded. Nobody loans to a startup that will probably fail. (There are some
startups with complex debt/equity/warrant deals which exist to get the tax
benefits of debt with the potential upside of equity. That's a tax gimmick,
not lending.)

The overall effect is conservative. By removing a Government policy which
distorts markets, we move back to a system where businesses are primarily
equity-funded. It returns companies to their historical role as payers of
dividends.

It's a good time for this change to business financing. Interest rates are
very low, so the tax impact is also low.

~~~
MarkMc
One thing I don't understand from the Economist article: Is there a difference
between (a) borrowing money and (b) borrowing land or machinery?

If a company cannot treat interest as a tax expense would that mean the cost
of renting office space is also not allowed?

~~~
rjtavares
There are rules to decide whether a lease counts as an asset for the company
(in which case part of the rent is interest).

IFRS states if any of these tests are met, the lease is considered a finance
lease:

-ownership of the asset is transferred to the lessee at the end of the lease term;

-the lease contains a bargain purchase option to buy the equipment at less than fair market value;

-the lease term is for the major part of the economic life of the asset even if title is not transferred;

-at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset.

-the leased assets are of a specialised nature such that only the lessee can use them without major modifications being made.

US GAAP has a similar provision.

~~~
rahimnathwani
The accounting rules to classify leases as {financial; operating} exist to
prevent companies from disguising financial leverage as operating leverage.
They are intended to ensure that the balance sheet represents a true and fair
view of the state of the company. They are not (primarily, at least) intended
to ensure that companies are taxed appropriately.

~~~
rjtavares
Yes, but that's because it was irrelevant. The same rule (albeit more
enforced) could be used for tax purposes in this case.

~~~
rahimnathwani
The tax implications are still, and will always be, irrelevant to accounting
rules. The purpose of accounting rules (like IFRS, US GAAP etc.) is to ensure
that companies' financial statements represent a true and fair view of the
state of the company.

This objective has nothing to do with tax.

------
tsotha
Personally I don't see any reason to provide a mortgage interest deduction for
homes, but any US politician who suggested removing it would be roundly
ejected from office immediately, both because home buyers are used to the
benefit and because it would align that politician against powerful interests
(construction, banking, and the money managers in government).

So as an intellectual exercise... yeah, sure. And there are probably
deductions businesses take that could be curtailed. But politics is the art of
the possible, and removing the mortgage interest deduction in the US ain't
ever going to happen.

~~~
rjsw
The experiment has already been done in the UK. House buyers stopped being
able to get a tax deduction on their mortgage interest in 2000 [1], people
still buy houses today.

The problem in the UK is that companies can still deduct the mortgage
interest, this puts people who buy property to rent out at an advantage.

[1]
[https://en.wikipedia.org/wiki/Mortgage_interest_relief_at_so...](https://en.wikipedia.org/wiki/Mortgage_interest_relief_at_source)

~~~
rahimnathwani
People who buy property to rent out also have to pay tax on the rental income.
It's just like any other business. You pay tax on your profit (revenue less
costs). In this case interest just happens to be one of the costs.

I'm not sure what you mean when you say these people have an 'advantage'?

~~~
groks
> I'm not sure what you mean when you say these people have an 'advantage'?

People who buy-to-let are not in the rental-income business, they are in the
business of acquiring property, because property prices are sky rocketing.

People with a job trying to get on the property ladder pay mortgage interest
with wages. People with second, third etc. properties deduct mortgage interest
as an expense.

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cm2187
The reason to do the same in the corporate world is that the debt bubble is
not only a retail debt bubble. Companies and states are also overusing debt.

LBOs are essentially leveraged tax arbitrage structures because tax
deductibility gives a strong incentive to leverage, a large part of the
economy is now overleveraged because of these structures. And we need to stop
with this idea that more debt is a hammer for every problem.

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ksar
Tax-deductible debt as it relates to financial engineering is what is tough to
rationalize. For example, the primary function of a PE-fund is to buy
ownership of a company by levering it up and then capturing tax shields (US
debt subsidy in this article). This is where 99% of the value generated by a
fund comes from. In my view, this is more or less a direct transfer of wealth
from the taxpayer to the PE-fund.

~~~
theseatoms
Is this true?

~~~
ksar
You could argue that the 'discipline of debt' imposed on the management of PE-
bought companies improves operational efficiency - because they need to
generate steady cash flow to delever the company. However, these guys lever to
the hilt with tonnes of cheap debt for a reason, though it's cheap it still
results in huge tax shields.

~~~
jessaustin
Having worked at a company in the throes of private equity management, I can
affirm that such "improvement" is _not_ a universal phenomenon. PE funds take
baths too.

~~~
hessenwolf
What does take a bath mean in this context? I keep hearing it.

~~~
jessaustin
To have very disappointing returns on an investment. Similar to "get soaked",
"get cleaned out", etc.

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Marazan
A key thing missing from the blog post about the article is that to raise
money instead of taking on debt companies would have more reason to issue
equity instead or various types of convertible notes.

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beefield
The writer fails to understand that the debt interest costs are not comparable
to business costs, but dividend payments on equity. Interest cost is a payment
for capital, as is dividend. If debt is favored in taxation over equity, it
causes the companies to be overleveraged, and I do not see what is the benefit
for society from that. (Note that the capital structure of company does not in
theory affect total value of business, see Modigliani & Miller)

~~~
rahimnathwani
"Interest cost is a payment for capital, as is dividend."

This is incorrect. Dividends are a distribution of money to those who already
owned the money. There is no economic transaction taking place.

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dang
Url changed from [http://blogs.law.harvard.edu/philg/2015/05/28/economist-
maga...](http://blogs.law.harvard.edu/philg/2015/05/28/economist-magazine-
argues-against-tax-deductible-debt/), which points to this.

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melling
Doesn't the market just build in the tax deductions into the prices?

~~~
pkaye
If that is the case, there is no disadvantage to removing the tax deductions.

