INSUBCONTINENT EXCLUSIVE:
By Andy MukherjeeFor 100 years now, capitalism has had a pro-leverage bias
Unlike dividends, which are paid only after the state has taken its share of earnings, interest is deducted from pretax profit, shrinking
the pie available to the government.
This accounting oddity, which treats debt capital more favorably than equity, has driven the leveraged
buyout industry, led to a correction in a foundational paper by a pair of Nobel economics winners, and played a role in the 2008 financial
Disaffection with this anomaly has long swirled as an undercurrent, especially in tax-starved developing economies
The coronavirus is reheating the debate.
Industrial losses may need to be socialized en masse to get displaced workers back on the job and
prevent the global economy from spiraling into depression
To manage the backlash against using public money for private gains, more countries are likely to follow the U.S
banking regulator, which have pushed for a halt to buybacks and dividends
But corporate rescue this time may also involve a rewriting of accounting rules to encourage deleveraging, so that bailouts are needed less
often and are less costly.
It was in 1918, when economists were likening the global spread of an excess profit tax on wartime corporate
income to the deadly outbreak of the Spanish flu, that the US relented and allowed all interest paid to be deducted from taxable profit
It was a temporary measure to give firms relief, but although the extra tax burden went away in 1921, the favorable treatment of interest
income stayed and was copied around the world.
The debt bias is very real
In the late 1950s, academics Franco Modigliani and Merton Miller controversially asserted that corporations should be indifferent to the mix
of debt and equity in their capital structure
Five years later, the professors issued a correction, acknowledging that a dollar of debt would raise the value of a firm by 50 cents, the
then-prevailing corporate tax rate.
The idea of a withholding tax on interest payments has done the rounds since at least 1982, but how does
a foreign investor or a tax-exempt local investor get credit? No country would want foreigners to shun its corporate debt and go where
Developing economies have also been ambivalent
Their tax authorities hate it when multinationals give loans to their profitable subsidiaries, thus reducing their taxable income in poor
attract large pools of Western savings by souping up shareholder returns with higher leverage
It helped that the cost of the debt was tax deductible
dividends.
After the 2008 crisis, policymakers looked aghast at the debt-financed expansion in banking over the previous three decades
noted in 2010, replacing the stock of financial sector debt with equity in just 14 countries would have required more than 60 per cent of
the then-existing global equity capital.
No wonder, then, that the world economy has kept accumulating debt
China stepped up borrowings to hold on to high growth in a slow-speed world; India wrecked its finance industry to achieve China-like
On the supply side, as banks retreated under regulatory pressure for more capital, private credit from insurers, pension funds and other
non-banks took their place, growing to a $300 billion industry by 2018 from $100 billion in 2010
tax code restricted interest deduction to 30 per cent of earnings before interest, tax, depreciation and amortization as an offset for
slashing the corporate rate to 21 per cent from 35 per cent
The U.K., too, put a limit.
But then came the coronavirus
The sheer scale of economic disruption and job losses means that governments and central banks will join hands
Disallowing interest deduction will generate resources as well as play into the zeitgeist for more public welfare.
As independent strategist
Gerard Minack noted recently, our world is primed to maximize financial returns on the assumption that nothing will go wrong
When things do, not just once but twice in 12 years, politicians must ask whether a smaller, more resilient firm, valued a little less than
before, is better than a large but fragile enterprise
Minack also believes that temporary restrictions on stock buybacks could be accompanied by changes to the tax treatment of debt.
With
industries of all hues begging governments for survival capital, rebates and even employee wages, bargaining power of firms is at rock
The unfinished tax reform agenda has a chance
Given that suppliers of debt financing are spread all over the world, a withholding tax on interest payments could cause dislocations
The only time to even attempt it is when faced with a disaster not encountered since the Spanish flu.
