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For individuals, the tax code is a lot less debt incentivizing than it used to be. Once upon a time, credit card interest and auto loans were itemized deductions.
A person can still use a HELOC in lieu of the other debts in order to get the deduction, though. They still have a net interest cost at any rate and this is really a separate issue from corporate debt.
They would still engage in *some* debt financing, just not as much as they do now. Retail outlets would probably still use vendor financing, for example, since it is not practical to use equity for that and holding a cash reserve would be unproductive during a good portion of each billing cycle.
If they use debt financing (assuming there is interest here) they will be worse off because they can't deduct the interest.
Quote:
Originally Posted by ncole1
This works both ways - equity is an expense to the bondholders, even though the contractual amounts the bondholders receive is fixed rather than depending on the company's profits. Think of it this way: When a company is seeking to take on debt, the company's anticipated expenses and the desired return on the shareholders' equity has an impact on how much interest bondholders can charge before the company will simply not take on the debt in the first place. Therefore, equity is an "expense" to the bondholders as it means they must charge less interest if they want to lend their money at all.
What in the world are you talking about? Equity is never an expense to a bondholder - it is collateral, albeit not always secured. Interest is an actual expense to the shareholders and they lose money that they would otherwise have. When a dividend is issued the shareholders are getting some of their money back since they own the corporation and the underlying assets.
Now it's true that debt financing only makes sense up to a certain point, but bondholders aren't privy to that info (normally). What bondholders do have access to are financials, the credit rating, and their overall risk. Risk based credit pricing has absolutely nothing to do with how much a company is willing to pay.
Quote:
Originally Posted by ncole1
A C corporation has to pay corporate income taxes, while an S corporation does not. Therefore, the preferential tax treatment of debt exists only for C corps and not for S corps.
So what? The only thing that changes are the tax brackets and some deductions are limited for an S corp based on ownership percentage and whether the shareholder is also an employee.
If they use debt financing (assuming there is interest here) they will be worse off because they can't deduct the interest.
Again, this could be remedied by lowering overall tax rates.
Quote:
Originally Posted by lycos679
What in the world are you talking about? Equity is never an expense to a bondholder - it is collateral, albeit not always secured. Interest is an actual expense to the shareholders and they lose money that they would otherwise have. When a dividend is issued the shareholders are getting some of their money back since they own the corporation and the underlying assets.
Now it's true that debt financing only makes sense up to a certain point, but bondholders aren't privy to that info (normally).
They aren't affected by that info as far as their existing bonds are concerned.
The company will consider a capital project if the stockholders believe it will yield an adequate return. Suppose that the stockholders want a return of 8%, and the company can buy a $1 million building which will yield 7% ($70k/year). A private bond investor is willing to lend the company the money for half of the building at 5% interest. This loan will cost $25k/year in interest (5% of $500k), so the profit is $45k/year. Since the company's invested capital is $500k, the return to the shareholders is 9% ($45k on $500k).
Thus, the shareholders will decide to go through with the project.
Now, suppose that at some later time, a different company is in a similar situation, only this time, the equity investors demand a 10% return. In that case, the deal will fall through, because the return is inadequate. The debt investor now is upset, because the money cannot be lent out if the borrower refuses to borrow. The debt investor may try to look elsewhere, but suppose no one will borrow at 5%. Now what happens?
Desperate, the debt investor offers to cut the rate to 3%.
Now the corporation's shareholders can do a re-evaluation. The $1 million building will yield $70k/year as before. Half of the cost will be borrowed at 3%, for an annual interest cost of $15k (3% of 500k.). This leaves $55k as profit for the shareholders, representing an 11% return on the equity contribution. The investors approve the project.
What has happened here? The higher cost of equity capital has forced the bondholder to accept a lower return.
Put differently, the cost of equity capital has cost the bondholder money. Ergo, the cost of equity capital is an expense to the bondholder!
Quote:
Originally Posted by lycos679
What bondholders do have access to are financials, the credit rating, and their overall risk. Risk based credit pricing has absolutely nothing to do with how much a company is willing to pay.
Risk based pricing is supply-side economics - relating to the lender's criteria. Pricing based on the shareholders' expectations is demand-side economics - relating to the borrower's criteria. Money will not be borrowed without both the lender's and the borrower's willingness to engage in the transaction, so you can't just claim it's only about one or the other!
Quote:
Originally Posted by lycos679
So what? The only thing that changes are the tax brackets and some deductions are limited for an S corp based on ownership percentage and whether the shareholder is also an employee.
Which has an impact on how much debt is ideal for the corp. due to its differing tax effects.
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.
That's not how it works. You're counting your chicks before they've hatched.
The shareholder must liquidate the stock in order to realize gains of any kind. Dividends are akin to "a bird in hand is worth two in the bush."
What you're doing is telling people, "Check's in the mail..."
Quote:
Originally Posted by ncole1
How does the priority of bondholders in a liquidation justify interest deductibility?
Bond-holders have a contract.
Stock-holders have a stake in the corporation, bond-holders do not.
There's something else that is incredibly obvious, and that is bonds are long-term debt, while stocks are not.
Quote:
Originally Posted by ncole1
So then the question is how to discourage the over-leveraging. The paper I reference in the OP makes the case that changes in the tax code are a good idea. If you don't believe this to be so, then what flaws do you see with the argument?
For one, the fact that you're considering EBIT shows me there's nothing here but smoke and mirrors.
Quote:
Originally Posted by lycos679
Off the top of my head:
You would kill corporate America's profits as they would either have to pay tax on the interest payments or retire the debt which would deplete their retained earnings account.
You would make it more difficult for smaller companies to grow as they could only grow via an equity infusion from an outside party or with their retained earnings, but could not grow via financing.
As companies would have to self finance their actions the economy would slow down.
Excellent.
I'm not totally on-board with Point #1, but Point #3 is spot on.
A lot of companies are buying back their own stocks. If companies are using their earnings to buy back their own stock, then they can't be using the earnings to raise wages or increase benefits, or expand production, or modernize their facilities or operations.
Quote:
Originally Posted by ncole1
A person can still use a HELOC in lieu of the other debts in order to get the deduction, though. They still have a net interest cost at any rate and this is really a separate issue from corporate debt.
And that is morally wrong.
Asking tax-payers to give up money to guarantee mortgages is one thing, but asking tax-payers to guarantee mortgages and HELOCS and 2nd and 3rd Mortgages and Refinancing is just plain wrong.
Quote:
Originally Posted by ncole1
Again, this could be remedied by lowering overall tax rates.
I'm not opposed to lower tax rates, but there must be a better reason that.
Quote:
Originally Posted by ncole1
The company will consider a capital project if the stockholders believe it will yield an adequate return. Suppose that the stockholders want a return of 8%, and the company can buy a $1 million building which will yield 7% ($70k/year). A private bond investor is willing to lend the company the money for half of the building at 5% interest. This loan will cost $25k/year in interest (5% of $500k), so the profit is $45k/year. Since the company's invested capital is $500k, the return to the shareholders is 9% ($45k on $500k).
Thus, the shareholders will decide to go through with the project.
Now, suppose that at some later time, a different company is in a similar situation, only this time, the equity investors demand a 10% return. In that case, the deal will fall through, because the return is inadequate. The debt investor now is upset, because the money cannot be lent out if the borrower refuses to borrow. The debt investor may try to look elsewhere, but suppose no one will borrow at 5%. Now what happens?
Desperate, the debt investor offers to cut the rate to 3%.
Now the corporation's shareholders can do a re-evaluation. The $1 million building will yield $70k/year as before. Half of the cost will be borrowed at 3%, for an annual interest cost of $15k (3% of 500k.). This leaves $55k as profit for the shareholders, representing an 11% return on the equity contribution. The investors approve the project.
What has happened here? The higher cost of equity capital has forced the bondholder to accept a lower return.
Put differently, the cost of equity capital has cost the bondholder money. Ergo, the cost of equity capital is an expense to the bondholder!
The flaw in your scenario is time-frame.
Also, you don't seem to understand the character traits, preferences and motives of bond-holders and stock-holders.
Bond-holders are in it for the long-term. Why do you think there are 30-year bonds?
Stock-holders prefer stocks in part, because they are easily liquidated for cash.
Bonds offer a more permanent form of certainty, while stocks do not. As a business, your interest payments and debt on bonds is known, is fixed, for the life of the bond. That's not so with stocks. You can't exactly predict what dividends will or will not be. You can't even predict future stock prices with any certainty.
The point being debt provides a degree of stability.
Capitalizing...
That's not how it works. You're counting your chicks before they've hatched.
The shareholder must liquidate the stock in order to realize gains of any kind. Dividends are akin to "a bird in hand is worth two in the bush."
What you're doing is telling people, "Check's in the mail..."
I doubt the average shareholder is as averse to earnings reinvestment as you make them out to be, otherwise the company wouldn't be reinvesting its earnings. The Board of Directors must keep most of the shareholders happy, or else...
Quote:
Originally Posted by Mircea
Bond-holders have a contract.
Stock-holders have a stake in the corporation, bond-holders do not.
There's something else that is incredibly obvious, and that is bonds are long-term debt, while stocks are not.
Please explain how you justify the differing tax treatment.
Quote:
Originally Posted by Mircea
For one, the fact that you're considering EBIT shows me there's nothing here but smoke and mirrors.
And your point is?
Quote:
Originally Posted by Mircea
Excellent.
I'm not totally on-board with Point #1, but Point #3 is spot on.
A lot of companies are buying back their own stocks. If companies are using their earnings to buy back their own stock, then they can't be using the earnings to raise wages or increase benefits, or expand production, or modernize their facilities or operations.
Are you assuming that the shareholders that sold the stock back to the company won't reinvest their capital elsewhere? If they do then that should roughly balance out the macroeconomic effects.
Quote:
Originally Posted by Mircea
And that is morally wrong.
Asking tax-payers to give up money to guarantee mortgages is one thing, but asking tax-payers to guarantee mortgages and HELOCS and 2nd and 3rd Mortgages and Refinancing is just plain wrong.
I think this is based on some misguided notions about the usage of money but I won't discuss it here since it would derail the thread.
Quote:
Originally Posted by Mircea
I'm not opposed to lower tax rates, but there must be a better reason that.
Does not compute!
Quote:
Originally Posted by Mircea
The flaw in your scenario is time-frame.
Both bonds and stocks may be held for a long time or sold to another investor, as is commonly the case with institutional investors.
Quote:
Originally Posted by Mircea
Also, you don't seem to understand the character traits, preferences and motives of bond-holders and stock-holders.
Bond-holders are in it for the long-term. Why do you think there are 30-year bonds?
Stock-holders prefer stocks in part, because they are easily liquidated for cash.
Bonds also can be sold for cash.
Quote:
Originally Posted by Mircea
Bonds offer a more permanent form of certainty, while stocks do not. As a business, your interest payments and debt on bonds is known, is fixed, for the life of the bond. That's not so with stocks. You can't exactly predict what dividends will or will not be. You can't even predict future stock prices with any certainty.
The point being debt provides a degree of stability.
Capitalizing...
Mircea
And this is reason to make interest deductible how exactly?
Again, this could be remedied by lowering overall tax rates.
There needs to be a valid reason to disqualify a valid business expense. You have already stipulated that if dividends were deductible then you would not have an issue with the current tax code.
Quote:
Originally Posted by ncole1
They aren't affected by that info as far as their existing bonds are concerned.
The company will consider a capital project if the stockholders believe it will yield an adequate return. Suppose that the stockholders want a return of 8%, and the company can buy a $1 million building which will yield 7% ($70k/year). A private bond investor is willing to lend the company the money for half of the building at 5% interest. This loan will cost $25k/year in interest (5% of $500k), so the profit is $45k/year. Since the company's invested capital is $500k, the return to the shareholders is 9% ($45k on $500k).
Thus, the shareholders will decide to go through with the project.
Now, suppose that at some later time, a different company is in a similar situation, only this time, the equity investors demand a 10% return. In that case, the deal will fall through, because the return is inadequate. The debt investor now is upset, because the money cannot be lent out if the borrower refuses to borrow. The debt investor may try to look elsewhere, but suppose no one will borrow at 5%. Now what happens?
Desperate, the debt investor offers to cut the rate to 3%.
Now the corporation's shareholders can do a re-evaluation. The $1 million building will yield $70k/year as before. Half of the cost will be borrowed at 3%, for an annual interest cost of $15k (3% of 500k.). This leaves $55k as profit for the shareholders, representing an 11% return on the equity contribution. The investors approve the project.
What has happened here? The higher cost of equity capital has forced the bondholder to accept a lower return.
Put differently, the cost of equity capital has cost the bondholder money. Ergo, the cost of equity capital is an expense to the bondholder!
At best case scenario you are arguing how a convertible could work. Banks, bondholders, etc. are going to price the loan based on the risk the borrower represents.
Quote:
Originally Posted by ncole1
Risk based pricing is supply-side economics - relating to the lender's criteria. Pricing based on the shareholders' expectations is demand-side economics - relating to the borrower's criteria. Money will not be borrowed without both the lender's and the borrower's willingness to engage in the transaction, so you can't just claim it's only about one or the other!
Even if that were true, and even though demand does come into play at the macro and to some extent micro level, risk based pricing is how we price credit products in the USA. In some countries, ex: Australia, you start off with a strong credit history and negative items drop your score, but in the USA you start off with no score and have to build it up before you can get the good terms..
Quote:
Originally Posted by ncole1
Which has an impact on how much debt is ideal for the corp. due to its differing tax effects.
Not so much. The individual rates are lower and more progressive so choosing S corp status makes sense until you make more than a certain amount of money. However, the higher rates under the corporate code just provide additional incentive for the corp to spend money, but it doesn't matter whether the money spend is on a sales team or interest as the net result is the same. If we were really encouraging debt we would be providing a bonus deduction, but we don't. Interest is just treated like every other expense.
Even if that were true, and even though demand does come into play at the macro and to some extent micro level, risk based pricing is how we price credit products in the USA. In some countries, ex: Australia, you start off with a strong credit history and negative items drop your score, but in the USA you start off with no score and have to build it up before you can get the good terms..
It sounds like you are talking about personal debt here as opposed to corporate debt.
There needs to be a valid reason to disqualify a valid business expense. You have already stipulated that if dividends were deductible then you would not have an issue with the current tax code.
At best case scenario you are arguing how a convertible could work. Banks, bondholders, etc. are going to price the loan based on the risk the borrower represents.
Even if that were true, and even though demand does come into play at the macro and to some extent micro level, risk based pricing is how we price credit products in the USA. In some countries, ex: Australia, you start off with a strong credit history and negative items drop your score, but in the USA you start off with no score and have to build it up before you can get the good terms..
Not so much. The individual rates are lower and more progressive so choosing S corp status makes sense until you make more than a certain amount of money. However, the higher rates under the corporate code just provide additional incentive for the corp to spend money, but it doesn't matter whether the money spend is on a sales team or interest as the net result is the same. If we were really encouraging debt we would be providing a bonus deduction, but we don't. Interest is just treated like every other expense.
So my question to you is: Why do you think it's better to go for single taxation and higher rates than it is to have double taxation and lower rates, despite the political near-impossibility of "raising tax rates"?
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.
Are you saying that R/E results in cap gains?
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