Finance & Investing

Francisco Pérez-González: How to Wean Businesses of Over-Borrowing

A novel tax-reform strategy in Europe reduces subsidies for taking on debt.

August 09, 2013

| by Edmund L. Andrews

If the financial crisis demonstrated anything, it was that excessive borrowing — leverage — can lead to big problems.

Yet while American households and businesses have trimmed back on debt since the crisis, the United States and most other nations still subsidize borrowing through the tax system. Businesses can deduct interest payments on debt, but not their dividends to shareholders. Homeowners reap huge tax deductions for interest on mortgages and home-equity loans.

The Treasury Department estimates that the effective marginal tax rate on financing new equipment is 37% in the United States if a company uses equity. If it borrows the money, however, the tax rate is a stunning negative 60%. Taxpayers are literally paying companies to borrow.

There are solid reasons for government to remove unnecessary obstacles to borrowing for companies and consumers alike. But tax policy experts have long complained that the tax code’s heavy bias in favor of debt over equity distorts financial decisions and can lead to excessive risk-taking by borrowers. The Obama administration has outlined a broad framework for tax reform that includes a call for reducing the bias, in part by reducing the deductibility of interest payments. But the practical and political obstacles are high, and no industrialized country has eliminated the deduction entirely. Now, a new study by three Stanford researchers offers fresh ammunition to reformers and explores an alternative reform that could make a difference. The study comes from Francisco Pérez-González, an assistant professor of finance at Stanford Graduate School of Business, and Frédéric Panier and Pablo Villanueva, both doctoral candidates at Stanford’s Department of Economics. (The paper won the Jaime Fernández de Araoz Corporate Finance Award, which was bestowed on all three researchers by Crown Prince Felipe of Spain at a ceremony in Madrid this June.)

Perhaps surprisingly, previous studies hadn’t conclusively established that the tax break for interest payments actually distorted firms’ financing decisions. Most experts have assumed that it did, but the effect has been hard to tease out from all the other factors that affect such decisions.


Recipient with award

The paper won the Jaime Fernandez de Aroaz award, which was bestowed on all three researchers by Crown Prince Felipe of Spain.

The new study tackles that headache by looking at the specific experience of Belgium, which enacted a dramatic reform in 2006 that helped level the financing playing field between debt and equity.

Belgium did not reduce the tax break for interest payments. Instead, it enacted a new tax deduction, based on a company’s equity, that helps neutralize the tax benefit of borrowing. The principle is very simple: allowing firms to deduct from their tax liabilities an interest charge that is proportional to the value of their equity. With this reform, new investments receive a tax deduction regardless of whether the source of the financing is debt or equity.

For Pérez-González, Belgium’s new tax maneuver offered an ideal opportunity to track how much the specific tax preference on interest payments increases corporate leverage.

The researchers began by comparing the leverage of Belgian firms before and after the new tax break was implemented. In addition, they compared the changes at Belgian firms with those of companies in bordering countries: France, Germany, the Netherlands, and Luxembourg.

In an important side benefit, the researchers were able to look not only at large, publicly traded corporations but also at relatively small, privately held firms. In contrast to the United States, where privately held companies don’t have to publicly disclose their finances, European governments require limited-liability companies to disclose at least their basic financials. That gave the researchers an unusually broad look at how a single tax preference affects basic business behavior across a wide set of firms in the economy.

The findings were decisive. The aggregate ratio of equity to total assets at Belgian firms jumped about 17% within two years, relative to the pre-reform levels.

Moreover, while the equity levels at Belgian firms were comparable to those in neighboring countries before 2006, Belgian equity levels became significantly higher afterward — especially for larger firms.

The equity increases of firms with asset values exceeding €100 million were 28%. At smaller firms, with asset values of €5 million to €25 million, the increase was 16%. At firms with assets of €25 million to €100 million range, the increase was 20%.

The researchers carefully weeded out the possibility that non-tax factors might have caused the dramatic shift in capital structures. The underlying economic growth in Belgium right before and after it introduced the tax deduction closely tracked the growth in the neighboring countries. To double-check for any geographic distortion in the data, the researchers took an extra look at non-Belgian companies that were close to the Belgian border. The results were no different than for companies that were farther away.

Of course, corporations are nimble at seizing on new tax preferences. Were the results explained by multinational companies simply shifting more assets into Belgian subsidiaries in order to take advantage of the new tax rules?

The answer was no. Though subsidiaries of multinationals increased equity levels more aggressively than stand-alone Belgian companies, both groups of companies dramatically increased their equity ratios.

So, what are the implications of this paper for the United States? In Washington, the chairmen of the House Ways and Means Committee and the Senate Finance Committee are once again pushing for a broad tax overhaul that lowers corporate rates and repeals many loopholes.

President Barack Obama announced his own framework for corporate tax reform in 2012, with many of the same principles as the committees’.

Would Belgium’s scheme be useful in the United States? Pérez-González says that what is essential is to have a rational debate about the merits and potential risks of a tax system that rewards leverage.

“Broadly defined, there are two policy tools to achieve tax neutrality with regard to financing decisions,” he says. “The first is to eliminate the existing tax subsidy for debt, and the second is to allow a similar deduction for equity.”

An important objection to a Belgian-style reform, he acknowledges, is that introducing an additional tax break would drain revenue at a time when governments around the world are struggling with large deficits.

But the fiscal cost doesn’t have to be big. For one thing, a new deduction for equity is likely to reduce borrowing and thus reduce deductions for interest payments. In a 2011 study, the International Monetary Fund estimated that Belgium’s new tax break had reduced corporate tax revenues by about 15%. But the IMF also noted that governments could minimize such losses by making other offsetting changes to their tax codes.

In addition, the IMF cautioned that eliminating the deductibility of interest creates its own problems. It doesn’t entirely eliminate the tax bias toward debt, and it will increase the cost of borrowing and business investment in general. As a result, the IMF said, nations that have reduced the deductibility of interest payments have also seen reductions in investment.

Pérez-González says he is agnostic about the best approach to reform. The key point, he says, is that his team’s paper lays to rest any lingering doubts that current tax policy induces companies to borrow more than they would otherwise. That poses both financial risks and broader risks to the public.

“A crucial driver of leverage is that we use the tax system to promote it, and leverage increases the fragility of the economic system,” he says. “Discriminating against equity financing is unnecessary, and it is also dangerous for the economy.”

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