I was reading Greg Mankiw dissing a tax increase proposal by Hillary Clinton, and I thought to myself, "If I could invent a tax increase for Greg Mankiw to dis, what would it be?" Suddenly, the screen began to waver, dreamy harp music chimed, and a vision appeared to me on a tablet of balance sheets: Eliminate the tax deductibility of interest payments by businesses. Debt financing externalizes the risks of business activity and magnifies social costs, while equity financing concentrates risk among stockholders who signed up to bear it. Yet under current rules, taxpayers literally pay firms to get rid of stockholders and take on ever more debt.
Here's the case-in-brief:
Creditors (people who lend to a firm) and equityholders (those who own stock) are fundamentally the same thing. Both are just investors, people who place money in the hands of a firm in hopes of getting it back later on, with a little something extra for their troubles. Whether one chooses to invest as a stockholder or bondholder is an idiosyncratic matter. Bondholders sacrifice potential upside for predictability and a legal right to enforce payments. Equityholders have no guaranteed payment schedule, but retain a potentially unlimited claim on a firm's future success. Firms pay bondholders according to a predetermined payment schedule, interest and principle. Equityholders are paid via dividends or share buybacks, but only when management is confident it has sufficient resources to pay debt obligations and fund firm operations. For those who grew up in the era of structured finanace, the equityholder/bondholder distinction is basically a primitive version of the tranching you'd find in a CDO. (There is the control thing that, as a historical quirk, usually goes exclusively to equityholders, but we'll put that aside for now. Creditors "own" a company as much as shareholders do, though the two groups have different sorts of rights associated with their claims.)
You'd think that the organization of investment contracts would be a private matter between people with money and people with good ideas about how to use it. But, that's not the case. Large-scale investment is crucial to a modern economy, and getting investors to trust strangers enough to give them their money is hard. So pretty much every government takes an interest in helping things out. Governments define forms of business organization, enforce accounting standards, and develop a body of law that mediates between managers and the various classes of investor. To overcome some of the trust issues, the most nervous sort of investor, bondholders, are given the business equivalent of a doomsday device to enforce their claim on timely payments. If, of malice or misfortune, a firm fails to pay out as promised, bondholders can force a firm into bankruptcy and coercively try to recover what they're owed. Though bankruptcy may be in bondholders' interest, it is quite traumatic for other firm stakeholders. There are two facts we should take note of: 1) bondholders owe an especial debt to the state, as the state, often at great cost, much more aggressively enforces creditors' rights than the rights of other investors; and 2) from a systemic perspective, a great predominance of bondholders — too much debt financing — is dangerous.
When an equity-funded firm underperforms, that mostly is a private matter that harms stockholders who knew the risks they were signing onto. When a debt-funded firm underperforms and cannot meet its obligations to bondholders, a sharp "nonlinearity" is provoked that frequently results in widespread harm to a firm's employees, suppliers, customers, and the communities in which it operates. If debt financing is very prevalent within the firm's "ecosystem", one firm's bankruptcy may cascade into widespread, even systemic, crises. Fundamentally, the right of bondholders to enforce their claims via bankruptcy is analogous to limited liability for investors of all classes — it's a legal convention we've developed to encourage socially useful risk-taking that partially externalizes the downside risks for some investors. While equity-funded firms fail as well, they have more leeway to temporarily underperform and recover, and the impact on firm stakeholders is usually more gradual and predictable.
Don't get me wrong. The existence of enforceable debt financing is a very good thing. It's an essential element of the constellation of institutions by which we are able to fund large-scale capital-intensive projects without coercion. But, the public incurs costs and risks by promising to enforce debt contracts. If a project is going to be funded regardless, any state meddling in capital structure ought to tilt the scales towards equity rather than debt financing.
But that's not what happens. Instead, corporate tax law strongly favors debt financing. One way or another, firms have to pay their investors. When firms pay stockholders, every dollar an investor receives drops off the firm's balance sheet. But when a bondholder receives the same dollar, a US firm pays as little as 65¢. The other 35¢ is paid for by Uncle Sam, in the form of a tax deduction. This creates a great incentive for firms to buyback shares and borrow money, that is to convert from equity financing to debt financing, when times are good and thoughts of bankruptcy seem remote. For example, here's Brad Setser, writing today about how the world looked one year ago:
There was no real risk to taking on more debt to reduce the amount of outstanding equity on a firms balance sheet and, in the process, increase the return on existing equity. Private equity firms had shown the way to arbitrage the difference between the pricing of debt and equity; all that remained was for everyone else to follow suit.
According to canonical financial theory a firm's debt/equity split, or "capital structure", should have no effect on overall firm value. It's just different ways of slicing up the same money pie, in a common metaphor. But if you introduce tax deductions for debt payments, the equation changes. Then the theory predicts that a rational firm should load up on debt financing, in order to capture the benefit of the "interest tax shelter". If bankruptcy were not an issue, rational firms would move to ~100% debt financing in order to extract the largest possible subsidy. With bankruptcy a possibility, a rational firm loads up on debt until the marginal increase in bankruptcy risk outweighs the marginal benefit of the subsidy. But if imperfect managers underestimate bankruptcy risk during periods of stability, they may unwittingly (or purposefully, if there are agency problems) bring firms close to the brink, provoking traumatic failures when the gales of an untamed business cycle blow strong and hard. By covering a large fraction of corporate interest payments, the government effectively subsidizes financial risk-taking that serves no operational purpose but generates real social costs.
So, here's my proposal: Put payments to stockholders and payments to bondholders on a level playing field. Eliminate the tax deduction for business interest payments. I'm not sure how much extra revenue this would net the Treasury, but by ending a perverse incentive for firms and eliminating a large subsidy to the wizards of debt, it would pay off hugely in the form of a more stable corporate and financial environment.
Note: Another way to level the playing field between debt and equity financing would be to eliminate corporate taxation entirely. I'd be cool with that too, as long as it was accompanied by a tax increase elsewhere whose incidence is at least as progressive as the corporate tax. Actually, eliminating the corporate income tax while making up the difference with a surge in top income tax brackets would be a fine stealth bailout for stock markets, funded by really rich people. Stocks would instantly be more valuable! And really, if we are going to socialize the costs of our financial meltdown, shouldn't we socialize it disproportionately to the people who gave it to us?
|Steve Randy Waldman — Tuesday January 22, 2008 at 3:23am||permalink|