Debt Versus Equity (Lex)

June 17th 2009

Economics invovles applying perfectly neat theories to a decidedly imperfect world-and taxes are one of those real-world foibles. A new study by IMF suggests that tax systems probably contributed to the financial crisis by encouraging companies to take on excessive debt.

Most current tax systems create incentives for companies to choose debt over equity funding. While interest payments serve to lower a company’s corporate tax bill, returns going to equity investors have no such benefit. (Furthermore, non-tax factors, such as encouraging a company to take on debt to constrain free-spending managers, can exacerbate this.) The higher the tax rate, the greater the incentive to leverage up and deploy debt’s tax deductibility. Evidence suggests that a 10-point rise in the tax rate increase debt to assets by some 2.7 percent. A general decline in corporate tax rates, then, is one reason why leverage among nonfinancial companies has been a two decade downward trend.

Private equity, however, made merry with the relatively low costs of debt, leveraging their targets to the hilt and, in turn, encouraging managers fearful of a takeover to do the same. Among banks, meanwhile, these tax distortions ran counter to regulatory good sense, representing an implicit penalty on building capital reserves. Using more debt0-like instruments in tier one capital arose, in part, form a desire to have the best of both worlds.

A similar tax benefit that reflected a notional cost of equity finance would level the playing field - a method used in Croatia, where studies suggest its introduction reduced debt ratios. As regulatory and accounting rules are redrawn after the crisis, tax systems should be tweaked to avoid favoring one species of capital over another.