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Joseph B. Allen argues in the paper, Seeking True Financial Reform: Ending the Debt-Equity
Distinction , that Congress failed to learn from the recent financial crisis the importance of keeping leverage under control.
Allen argues that the economy would be more stable if the tax code were to be reformed to avoid incentivizing companies to use debt financing rather than equity financing. Although there are certainly other frictions and inefficiencies that can cause deviation of market values from Modigliani-Miller, I think the argument is a good one.
I hereby propose that the tax deduction for corporate interest be phased out over the next 20 years.
The idea is that the bondholders and stockholders alike have provided the company with the usage of their capital and get paid something in return - interest and dividends, respectively. The current system is based on the idea that interest is an expense while dividends are not. However, from the company's perspective, both dividends and interest represent payments to investors (debt investors and equity investors, respectively.) The only difference is that interest payments on a bond are fixed obligations, while dividend payments are variable obligations. But this distinction doesn't warrant a difference in tax treatment.
Suppose a corporation needs to raise $15mm. One way to do it is all equity. Suppose a rich individual buys ALL the shares at IPO. Now each dollar of EBIT gets taxed at the corporate rate, and then at the (individual) dividend rate.
Suppose, on the other hand, the company finances $5mm with corporate bonds and the other $10mm with equity. Again assume the investor buys all the shares, and also buys all the bonds. Now what? The company's EBIT is the same as in the other case. A portion of that pays interest and the rest dividends. The dividend dollars, as in the first case, get taxed once at the corporate rate and once at the individual dividend rate. So far so good. But what about the interest dollars that also are coming from the company's EBIT? They do not get taxed at all at the corporate level since the interest is deductible. Only after the bondholder receives it is it taxed, at the level of individual ordinary income.
Thus, only some of the company's EBIT is double-taxed, while in the first scenario, all of it is double-taxed. So the ultimate after-tax income of the investor is higher if the company has debt than if it doesn't, even though the EBIT is the same in both cases and the investor would receive the same total income in both cases absent tax differences.
The idea is that the bondholders and stockholders alike have provided the company with the usage of their capital and get paid something in return - interest and dividends, respectively. The current system is based on the idea that interest is an expense while dividends are not. However, from the company's perspective, both dividends and interest represent payments to investors (debt investors and equity investors, respectively.) The only difference is that interest payments on a bond are fixed obligations, while dividend payments are variable obligations. But this distinction doesn't warrant a difference in tax treatment.
Suppose a corporation needs to raise $15mm. One way to do it is all equity. Suppose a rich individual buys ALL the shares at IPO. Now each dollar of EBIT gets taxed at the corporate rate, and then at the (individual) dividend rate.
Suppose, on the other hand, the company finances $5mm with corporate bonds and the other $10mm with equity. Again assume the investor buys all the shares, and also buys all the bonds. Now what? The company's EBIT is the same as in the other case. A portion of that pays interest and the rest dividends. The dividend dollars, as in the first case, get taxed once at the corporate rate and once at the individual dividend rate. So far so good. But what about the interest dollars that also are coming from the company's EBIT? They do not get taxed at all at the corporate level since the interest is deductible. Only after the bondholder receives it is it taxed, at the level of individual ordinary income.
Thus, only some of the company's EBIT is double-taxed, while in the first scenario, all of it is double-taxed. So the ultimate after-tax income of the investor is higher if the company has debt than if it doesn't, even though the EBIT is the same in both cases and the investor would receive the same total income in both cases absent tax differences.
This is the tax preference of debt.
From an owner's standpoint with no tax consideration I may prefer debt issuance to secondary because of the dilution of my ownership share
The idea is that the bondholders and stockholders alike have provided the company with the usage of their capital and get paid something in return - interest and dividends, respectively. The current system is based on the idea that interest is an expense while dividends are not. However, from the company's perspective, both dividends and interest represent payments to investors (debt investors and equity investors, respectively.) The only difference is that interest payments on a bond are fixed obligations, while dividend payments are variable obligations. But this distinction doesn't warrant a difference in tax treatment.
Suppose a corporation needs to raise $15mm. One way to do it is all equity. Suppose a rich individual buys ALL the shares at IPO. Now each dollar of EBIT gets taxed at the corporate rate, and then at the (individual) dividend rate.
That isn't a reason to tax a company on money they no longer have. In essence you are adding another layer of double taxation Once at the corporate level and then at the personal level or Corp level then corporate level then personal level (if debt is owned by another corp that issues dividends - such as a bank).
Another issue I have is the equity investors are not guaranteed any dividends at all or even their original investment, but the bondholders are so there isn't any reason to try and argue the 2 are the same. Now if you were to argue that we should get rid of double taxation I could agree with you.
In truth, you could eliminate the interest deductibility, but I fail to see how that would be economically desirable when the debt is used for business purposes.
That isn't a reason to tax a company on money they no longer have. In essence you are adding another layer of double taxation
It is not another layer of double taxation - it is just applying the double taxation to debt dollars as well as equity dollars rather than just to equity dollars.
Quote:
Originally Posted by lycos679
Once at the corporate level and then at the personal level or Corp level then corporate level then personal level (if debt is owned by another corp that issues dividends - such as a bank).
Another issue I have is the equity investors are not guaranteed any dividends at all or even their original investment, but the bondholders are so there isn't any reason to try and argue the 2 are the same.
The argument would be that retained earnings also benefit the shareholders; they simply mean the shareholders are taking the company's profits in the form of capital gains on their shares rather than dividends.
Now if you are addressing the fact that the company might fall on hard times and cause the equity investor to lose money all things considered, then the response is that they are already compensated for that via the equity premium.
Quote:
Originally Posted by lycos679
Now if you were to argue that we should get rid of double taxation I could agree with you.
In truth, you could eliminate the interest deductibility, but I fail to see how that would be economically desirable when the debt is used for business purposes.
Ok, I'm fine with getting rid of double taxation and just increasing tax rates to compensate...
From an owner's standpoint with no tax consideration I may prefer debt issuance to secondary because of the dilution of my ownership share
It's not dilution, it's leverage. That said, if the company can borrow more cheaply than you and your risk tolerance is larger than that of corresponding unlevered asset(s), then it makes sense for you to want the company to take on debt.
More accurately, holding a corporation with debt also gives you the advantage of downside protection - if the company goes bust you end up with nothing, whereas if you borrow money as an individual you might end up with less than nothing. In this sense, it might make sense even if the corporation's borrowing rate is somewhat higher than yours (or the rate at which you lend, if you hold fixed income assets that you would sell in lieu of borrowing.), since the difference in interest costs could be considered as an "insurance premium" against the downside.
So it is certainly true that there would still be corporate debt in a world with no tax advantage; but less of it. My argument is that a little corporate debt is much better for society as a whole than a lot of corporate debt, because excessive leverage destabilizes the economy and it takes much less of a slowdown in the economy to cause a big recession than would be the case if the companies held less debt (but still some debt).
Joseph B. Allen argues in the paper, Seeking True Financial Reform: Ending the Debt-Equity
Distinction , that Congress failed to learn from the recent financial crisis the importance of keeping leverage under control.
Allen argues that the economy would be more stable if the tax code were to be reformed to avoid incentivizing companies to use debt financing rather than equity financing. Although there are certainly other frictions and inefficiencies that can cause deviation of market values from Modigliani-Miller, I think the argument is a good one.
I hereby propose that the tax deduction for corporate interest be phased out over the next 20 years.
Congress could start by looking in the mirror
Once the government gets their own house in order, they are then welcome to reform how they incentivize business practices.
Other than that, I agree that the idea is worth considering.
Once the government gets their own house in order, they are then welcome to reform how they incentivize business practices.
Other than that, I agree that the idea is worth considering.
Indeed.
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