In a paper on tax policy, leverage and macroeconomic stability published on 10 November, the IMF staff address the issue of excessive leverage or the so-called “debt bias” that poses risks for financial and macroeconomic stability. The “debt bias” has been largely created by more favorable tax treatment of debt relatively to equity. In most jurisdictions, interest is a tax deductible expense for corporations while payments to equity holders are not. According to the paper, this results in a substantial increase in the debt to assets ratio. In addition, many countries allow people to deduct mortgage interest for personal income tax purposes and/or tax interest income more favorably than dividend income, further increasing the relative appeal of debt.
The return of Modigliani and Miller
The economics behind the issue is not new at all. It’s been more than half a century now since the Nobel-prize winning economists Merton Miller and Franco Modigliani first formulated their famous proposition that in perfect capital markets the value of a company does not depend on its financing structure. In other words, the value of the real assets of a company does not change if you load more debt onto it, the value of equity simply decreases by the corresponding amount. Another way to formulate it is that the weighted average cost of capital of a company stays constant independent of the weights of debt and equity in the financing structure because an increase of the debt burden results in the equity becoming more risky and equity holders requiring higher returns.
Real life capital markets are far from perfect, they are full of different types of friction – taxes, subsidies and costs of financial distress, to name just the most common ones. Thus, the proposition was amended to take into account these effects. The reasoning went as follows – as interest expenses are tax deductible while payments to equity investors are not, increasing the weight of debt in the financing structure would decrease the weighted average cost of capital and increase the value of the company. This would be true until you reach the point of optimal capital structure beyond which the growing leverage increases the probability of bankruptcy to such an extent that the present value of the estimated costs of financial distress outweighs any further gains in company value achieved by additional borrowing.
However, the “debt bias” that was value maximizing from the point of view of individual companies created a risk to financial and macroeconomic stability, which materialized during the recent financial crisis. Capital structures that may have been optimal for individual companies turned out to be suboptimal for the economy as a whole and contributed to deepening of the financial crisis. In a similar manner, mortgage interest deductibility for personal income tax purposes motivated households to borrow more than they would have otherwise and drove real estate prices higher, often to a large extent offsetting the gain from interest deductibility.
We all know what happened then. Central banks and governments throughout the world had to act to make sure that deleveraging happened in an orderly manner – without setting off what is called a Minsky moment – a vicious circle of deleveraging, bankruptcies, unemployment, falling demand and lower asset prices, which would cause more and more malaise. Taxpayers were forced to spend huge amounts of money to bail out insolvent banks because letting them fail would have been even more expensive – if you added to the costs of deposit insurance the negative consequences for the financial system and the real economy. As a result, a part of the excessive private sector debt ended up on government balance sheets. However, one of the underlying causes of excessive borrowing – the more favorable tax treatment of debt relatively to equity, today is still not eliminated.
The pros and cons of IMF recommendations on the issue
The current recommendations made by the IMF to reduce the “debt bias” are exactly along the lines that Modigliani and Miller would have suggested. Basically, they boil down to eliminating the frictions in the capital markets created by more favorable tax treatment of debt relatively to equity. At the corporate level this can be done in two ways – by reducing or eliminating interest tax shields or introducing a “dividend tax shield” or something that the IMF refers to as “Allowance for Corporate Equity” (ACE). At the individual level it is basically about eliminating mortgage interest deductibility. Both of these suggestions, however, face barriers to implementation.
Introduction of ACE would reduce corporate income tax revenue for governments at a time when the public finances of most advanced economies are still in deficit. Many countries can ill afford such a move, unless it is compensated by raising other taxes. The countries that can afford to implement ACE now are most likely those with already lower risks to macroeconomic and financial stability. If they introduce ACE, but other, more vulnerable countries don’t, that would do little to reduce the risk to the global financial system as a whole. In addition, ACE has the (more conceptual) drawback of fighting the effects of one friction by adding another friction. It would also go against the aim to simplify the tax system. As a doctor once put it to one of us – it’s like ordering a patient who has acid intoxication to drink a bit of base to neutralize it.
The other path – gradual elimination of tax deductibility of interest – both for corporate borrowing and individual mortgages would be the theoretically correct way to go as it would eliminate the initial friction that caused the “debt bias” in the first place. It would help reduce the buildup of risks to financial and macroeconomic stability in the first place rather than create more reliable tools to deal with the consequences. Further, it would also help generate additional revenue for governments. However, with trillions of debt outstanding, it would also represent a seismic shift in the economy and the financial system that would affect everything from credit risk assessment and loan covenants to share prices. To reduce the impact of such a shock, interest tax shields could at best be eliminated only gradually, with long transition periods in place. Again, it has to be considered that if some countries do it, but others don’t, businesses in the latter would obtain a temporary advantage in form of lower weighted average cost of capital. Thus, the policy move should be coordinated among as many countries as possible. However, if interest tax shields are to be eliminated, the time to start doing it is now when the interest rates are low. Sooner or later interest rates will rise again, strengthening the opposition against eliminating interest tax deductibility. If so, the “debt bias” will be here to stay and likely contribute to further crises in the future.
References
IMF. 2016. Tax Policy, Leverage and Macroeconomic Stability. 10 November.
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