Tax-Free Debt: The great distortion
economist.com
economist.com
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.
This comic summarizes it perfectly: http://i.imgur.com/Lw61YGs.gif
Taxing dividends would be like taxing ATM withdrawals.
Tax the income not the withdrawal.
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?
Why shouldn't they? They are two different situations. Different situations can lead to different outcomes.
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.
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 the situations are not economically identical. That was not a useful over-simplification on my part.
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.
Wages are a pre-tax expense for the corporation.
(The required holding period is 60 days during the 121-day period that begins 60 days before the ex-dividend date.)
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.
And by wholesale broker I also included retail deposits.
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.
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.
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.
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.
If a company cannot treat interest as a tax expense would that mean the cost of renting office space is also not allowed?
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.
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.
This objective has nothing to do with tax.
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.
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.
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.
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.
I suspect property values would drop if they removed the exemption, which would make a whole lot of people very unhappy.
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...
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.)
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.
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.
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 incorrect. Dividends are a distribution of money to those who already owned the money. There is no economic transaction taking place.