Tax-Free Debt: The great distortion(economist.com)
economist.com
Tax-Free Debt: The great distortion
http://www.economist.com/news/leaders/21651213-subsidies-make-borrowing-irresistible-need-be-phased-out-great-distortion
9 comments
I read last week's Economist.
I agree that mortgage interest payments should not be tax-deductible for individuals. This distorted house prices in the UK until MIRAS was abolished many years ago, but the same situation exists today in the USA.
I disagreed with most of the rest, which addressed interest paid by businesses. I don't agree that interest payments are a special type of business expense that should be treated differently from others (like rent). If you accept that businesses should be taxed based on the profit they make, then singling out interest as a non-tax-deductible expense means that some businesses would pay profits tax, even when their accounts show zero or negative profit. It would also create perverse incentives:
- If I need capital for my business, but don't want to give up control, I will have to create an additional class of shares, and issue more shares whenever I need to 'borrow' more money
- If I need equipment for my business, I'll try and rent it instead of buying it, even though I intend to use the equipment until it's on its last legs. Oh, and the deal I'll strike will take this into account, so under IFRS it will be classed as a finance lease, so my controller will need to spend time explaining that to the auditors. Yay.
I agree that mortgage interest payments should not be tax-deductible for individuals. This distorted house prices in the UK until MIRAS was abolished many years ago, but the same situation exists today in the USA.
I disagreed with most of the rest, which addressed interest paid by businesses. I don't agree that interest payments are a special type of business expense that should be treated differently from others (like rent). If you accept that businesses should be taxed based on the profit they make, then singling out interest as a non-tax-deductible expense means that some businesses would pay profits tax, even when their accounts show zero or negative profit. It would also create perverse incentives:
- If I need capital for my business, but don't want to give up control, I will have to create an additional class of shares, and issue more shares whenever I need to 'borrow' more money
- If I need equipment for my business, I'll try and rent it instead of buying it, even though I intend to use the equipment until it's on its last legs. Oh, and the deal I'll strike will take this into account, so under IFRS it will be classed as a finance lease, so my controller will need to spend time explaining that to the auditors. Yay.
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).
"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
This comic summarizes it perfectly: http://i.imgur.com/Lw61YGs.gif
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?
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?
If you paid out the profit of the corporation as a dividend, and you have owned the corporation for a long time* so those are “qualified dividends” in the US, and your ordinary income tax rate is 30%, then you only pay 15% tax on those dividends. That leaves you with $68k, or only slightly less than the other scenario.
(The required holding period is 60 days during the 121-day period that begins 60 days before the ex-dividend date.)
(The required holding period is 60 days during the 121-day period that begins 60 days before the ex-dividend date.)
> 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.
Wages are a pre-tax expense for the corporation.
Wages are a pre-tax expense for the corporation.
Why shouldn't you pay more for receiving the liability benefits of a corporation?
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.
Why shouldn't they? They are two different situations. Different situations can lead to different outcomes.
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.
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.
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.
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.
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.
You are right that the situations are not economically identical. That was not a useful over-simplification on my part.
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.
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.
That comic is idiotic. The dividend is not a payment for a service or purchase. It's simply a transfer of income someone earned.
Taxing dividends would be like taxing ATM withdrawals.
Tax the income not the withdrawal.
Taxing dividends would be like taxing ATM withdrawals.
Tax the income not the withdrawal.
Interestingly, the UK didn't used to tax dividends twice. This practice only started in 1999. Prior to that, dividends issued by UK companies were treated as if the recipient had already paid income tax on the amounts received. Only if the recipient was a higher rate taxpayer, were they on the hook for (just) the excess.
http://en.m.wikipedia.org/wiki/Advance_corporation_tax
http://en.m.wikipedia.org/wiki/Advance_corporation_tax
There's nothing special about a bank's business model that requires its profits to be taxed differently from those of other companies.
Incidentally, your characterisation of banks as wholesale brokers of debt is not strictly true. Sure, banks do broker lending transactions between parties. Sure, they do sometimes act as servicers for paper which is held by other investors. However banks are, in the main, risk machines. They borrow money (on their own account) and lend it to others (on their own account). Depositors are their suppliers, and borrowers are their customers. In this activity, they are not brokers. They are wholesalers/retailers, just like other trading companies.
Incidentally, your characterisation of banks as wholesale brokers of debt is not strictly true. Sure, banks do broker lending transactions between parties. Sure, they do sometimes act as servicers for paper which is held by other investors. However banks are, in the main, risk machines. They borrow money (on their own account) and lend it to others (on their own account). Depositors are their suppliers, and borrowers are their customers. In this activity, they are not brokers. They are wholesalers/retailers, just like other trading companies.
But in this activity the interest they receive on their assets (their lending) is not a revenue. What is revenue to a bank is the different between the interest received and the interest paid plus any other fee.
And by wholesale broker I also included retail deposits.
And by wholesale broker I also included retail deposits.
What you have written is incorrect.
For a bank, interest it receives on its assets IS revenue. The difference between the interest received and the interest paid is their _profit_.
With regard to retail deposits, bank absolutely do not act as brokers. They are not middlemen. Depositors lend money to the bank. The liability shows up on the bank's balance sheet. If banks were acting as brokers, who is the principal on the other side of the deposit transaction?
EDIT: Don't confuse the terms 'Revenue' and 'Net Revenue' when reading a bank's accounts. 'Net' has a meaning!
EDIT 2: The words 'income' and 'revenue' are generally interchangeable.
EDIT 3: I don't think we agree on the definition of the word 'broker'. When I say 'wholesaler', I mean someone who buys something with the intention of selling it at a higher price. When I say 'broker', I mean someone who brings together two parties, and is paid a commission by one or both parties, for his/her part in helping the two parties making a deal between themselves.
For a bank, interest it receives on its assets IS revenue. The difference between the interest received and the interest paid is their _profit_.
With regard to retail deposits, bank absolutely do not act as brokers. They are not middlemen. Depositors lend money to the bank. The liability shows up on the bank's balance sheet. If banks were acting as brokers, who is the principal on the other side of the deposit transaction?
EDIT: Don't confuse the terms 'Revenue' and 'Net Revenue' when reading a bank's accounts. 'Net' has a meaning!
EDIT 2: The words 'income' and 'revenue' are generally interchangeable.
EDIT 3: I don't think we agree on the definition of the word 'broker'. When I say 'wholesaler', I mean someone who buys something with the intention of selling it at a higher price. When I say 'broker', I mean someone who brings together two parties, and is paid a commission by one or both parties, for his/her part in helping the two parties making a deal between themselves.
That not the way I read a bank income statement. If we take the example of JPMorgan (p3):
http://files.shareholder.com/downloads/ONE/239936797x0x82007...
Revenue is defined as Non interest revenue (fees) plus interest income minus interest expense.
This is typical for banks. And there is a reason for that. A bank is effectively a wholesale buyer (lender) and seller (borrower) of debt, through loans and deposits. The interest paid and received is essentially pass-through.
Revenue is defined as Non interest revenue (fees) plus interest income minus interest expense.
This is typical for banks. And there is a reason for that. A bank is effectively a wholesale buyer (lender) and seller (borrower) of debt, through loans and deposits. The interest paid and received is essentially pass-through.
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.
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.
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?
If a company cannot treat interest as a tax expense would that mean the cost of renting office space is also not allowed?
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.
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.
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.
Yes, but that's because it was irrelevant. The same rule (albeit more enforced) could be used for tax purposes in this case.
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.
This objective has nothing to do with tax.
You are right. There is no meaningful difference.
Capital is just one of several things a business needs in order to operate. Singling it out as something which must be added back to profits (before profit tax is calculated) doesn't make much sense.
If a government enacted such laws, accounting firms would be quick to respond by creating new tax avoidance schemes. Complicating the tax code wastes brain power.
Capital is just one of several things a business needs in order to operate. Singling it out as something which must be added back to profits (before profit tax is calculated) doesn't make much sense.
If a government enacted such laws, accounting firms would be quick to respond by creating new tax avoidance schemes. Complicating the tax code wastes brain power.
I'm not an economist, but leasing an asset like land or machinery doesn't allow a company to lever up its balance sheet.
Signing a 25-year lease on a piece of land is very similar to borrowing the money to buy the land.
You are right, the 25-year lease probably wouldn't show up on the balance sheet as a liability. This reflects a limitation in how we do accounting (backward-looking value measurement), not an underlying difference in the economic reality.
You are right, the 25-year lease probably wouldn't show up on the balance sheet as a liability. This reflects a limitation in how we do accounting (backward-looking value measurement), not an underlying difference in the economic reality.
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.
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.
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...
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...
> 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.
Not just companies in the usually-understood sense; private landlords can deduct mortgage interest on the property they let as an expense to reduce their tax bill. No need to set up a company or actually declare yourself as self-employed or whatever. (Conceptually they are running a business, but there's no need for a company.)
Not just companies in the usually-understood sense; private landlords can deduct mortgage interest on the property they let as an expense to reduce their tax bill. No need to set up a company or actually declare yourself as self-employed or whatever. (Conceptually they are running a business, but there's no need for a company.)
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'?
I'm not sure what you mean when you say these people have an 'advantage'?
> 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.
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.
That's why you need to be more sneaky about it.
In Denmark you used to be able to deduct interest 100% as far as I'm aware. According to
http://da.wikipedia.org/wiki/Rentefradrag
it's then been gradually decreased from 73% in 1987 to 32% in 2001. And there's a plan to decrease it further, although it is, as you point it, a really hot topic every time it comes up - "driving people from their homes" and similar headlines.
In Denmark you used to be able to deduct interest 100% as far as I'm aware. According to
http://da.wikipedia.org/wiki/Rentefradrag
it's then been gradually decreased from 73% in 1987 to 32% in 2001. And there's a plan to decrease it further, although it is, as you point it, a really hot topic every time it comes up - "driving people from their homes" and similar headlines.
I should perhaps add that in Denmark there's an academic economic elite of researchers (with titles as "wise men", no kidding) that get a lot of attention from the press, and since the set of people elected to the parliament in many cases have a Master's degree in economic or state science where these people teach, their advice is taken really seriously.
For instance, the current government which is nominally social-democratic did some pretty serious cuts to various tax-funded welfare programmes, on the advice of the wise men, to the dismay of their voters.
For instance, the current government which is nominally social-democratic did some pretty serious cuts to various tax-funded welfare programmes, on the advice of the wise men, to the dismay of their voters.
We don't have group like that in the US. I'm not sure it would matter even if we did.
Oh, but the funded think-tanks?
Nobody cares what they think, really. They get quoted because the media has to have something to write about.
I suspect property values would drop if they removed the exemption, which would make a whole lot of people very unhappy.
I suspect property values would drop if they removed the exemption, which would make a whole lot of people very unhappy.
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.
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.
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.
[deleted]
Is this true?
http://dealbook.nytimes.com/2013/04/15/the-top-10-private-eq...
This is relevant to technology. Look at PE influence on Microsoft's board and the strategy to deprioritize Windows, Dell going private, and the recent purchase (and possible breakup) of Broadcom. There's probably more.
This is relevant to technology. Look at PE influence on Microsoft's board and the strategy to deprioritize Windows, Dell going private, and the recent purchase (and possible breakup) of Broadcom. There's probably more.
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.
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.
What does take a bath mean in this context? I keep hearing it.
To have very disappointing returns on an investment. Similar to "get soaked", "get cleaned out", etc.
Well when a company fails we also say it's "going under"...
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.
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)
"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.
This is incorrect. Dividends are a distribution of money to those who already owned the money. There is no economic transaction taking place.
Url changed from http://blogs.law.harvard.edu/philg/2015/05/28/economist-maga..., which points to this.
Doesn't the market just build in the tax deductions into the prices?
If that is the case, there is no disadvantage to removing the tax deductions.
If this is the case, we should phase these deductions out.
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.