Debt Versus Equity (Subsidized Leverage)

"Tax distortions have caused leverage to be substantially higher than it would have been under a neutral tax system"

"On an individual level, many countries offer tax benefits for homeowners as opposed to renters. Some offer tax relief on mortgage interest, including the US, Spain, France and Italy........ they did encourage mortgage borrowing and the accumulation of household debt."

IMF blames tax distortions for helping to fuel credit boom

By Sarah O'Connor in Washington

Published: June 17 2009 03:00 | Last updated: June 17 2009 03:00

Tax policies helped to fuel the credit boom by encouraging borrowing by companies and individuals, the International Monetary Fund said yesterday as it suggested countries change their tax rules to reduce such incentives.

The IMF said tax regimes in most countries encouraged companies to finance themselves with debt rather than equity and also made it cheaper for people to take out mortgages. Such policies contributed to an unsustainable build-up of credit, the collapse of which propelled the world into recession.

"We're not saying tax was the cause of the crisis [but] we do see some tax fingerprints at the scene of the crime," said Michael Keen, assistant director of tax policy at the IMF's fiscal affairs department.

Most tax regimes allow companies to deduct interest payments against tax, but not returns on equity. Leveraged buy-outs by private equity companies benefited substantially from this tilt towards debt, but the IMF said other companies were also pushed towards debt-financing by the rule.

"Tax distortions have caused leverage to be substantially higher than it would have been under a neutral tax system," it said in a report yesterday.

There was a "strong case" for countries to change their tax systems to create a level playing field between debt and equity, the report said. It suggested two ways to do this: eliminate the deductibility of interest payments, which would be politically fraught, or create some kind of deductibility for the notional cost of equity financing.

The latter would be the better route, the IMF argued. For banks, it would amount to giving tax deductions on Tier 1 capital, thus encouraging them to build better capital reserves.

Several countries have adopted so-called Allowance for Corporate Equity rules. However, such a policy can radically reduce the amount of tax revenue a government pulls in, at a time when many governments' finances are strained. Croatia's corporate tax base might have fallen by a third as a result of the rule, the IMF said.

On an individual level, many countries offer tax benefits for homeowners as opposed to renters. Some offer tax relief on mortgage interest, including the US, Spain, France and Italy. While the IMF did not find evidence that such policies caused the jump in house prices that occurred before the crash, it said they did encourage mortgage borrowing and the accumulation of household debt.

"We're not drawing from that conclusion that one should instantly remove all these housing tax privileges," Mr Keen said. "That's clearly not something one would want to do until the housing markets have come back to some sort of normality. But, on the other hand, we would be cautious about adding new privileges of this kind, which could store up future problems."

The Organisation for Economic Co-operation and Development has been investigating the same issue, and is drawing similar conclusions.