By John Plender
Published: March 24 2010 18:44
The heated debate on the taxation of bank bonuses has distracted attention from a glaring omission in current policy proposals to put the financial system to rights. This is the tax bias that exists in favour of debt at the expense of equity in the US and UK, which are the countries that matter most for global financial stability. It is a bias that potentially undermines the thrust of regulatory efforts to strengthen bank balance sheets.
As David Miles, a member of the Bank of England’s monetary policy committee, has pointed out, the tax treatment of interest is one of the explanations for the explosive growth of the banking sector in recent years. In effect, this fiscal quirk penalises the accumulation of reserves and encourages banks (as well as other companies) to take on leverage – that is, to finance the business with debt rather than equity. For banks, this minimises costly capital requirements and boosts returns to shareholders. Since interest payments are deductible against corporate taxes whereas equity returns are not, non-financial companies too have a powerful incentive to issue debt.
A recent paper from the International Monetary Fund leaves no doubt that such tax distortions encouraged excessive bank leverage before the crisis. “Corporate-level tax biases favouring debt finance ... are pervasive, often large – and hard to justify given the potential impact on financial stability,” it declares. Yet few appear to be listening, despite the fact that high leverage and reliance on volatile wholesale funds were the proximate cause of most banks’ problems in the financial crisis.
In the wider corporate sector this tax bias can also be damaging. Excessive debt leaves companies vulnerable to shocks, especially in recession. When borrowing is in effect subsidised in this way it can also distort investment decisions, turning unprofitable projects into profitable ones and influencing multinational companies’ decisions on where to invest.
There are strong arguments for a more neutral treatment of equity and debt on grounds of economic efficiency and fairness. If income from capital is to be taxed, why should income from capital that is financed by debt be exempt? Such arguments are hugely magnified in the light of the financial crisis. So what should be done?
Broadly, there are two ways to address this anomaly. One is to keep interest deductability and make the notional cost of equity finance tax deductible. This has been tried in countries including Belgium, Croatia and Brazil. The IMF cites evidence that debt-to-equity ratios have declined as a result. For banks it is equivalent to a tax allowance for Tier 1, or high quality, capital. The penalty for accumulating reserves is thus removed.
The snag is that this reduces tax revenue and narrows the tax base – the assets and income available to be taxed. The switch to giving relief for equity finance is reckoned to have cost Croatia up to a third of corporate tax income. Raising headline rates of corporation tax to compensate is politically difficult.
The alternative is to restrict or eliminate interest deductability. This would allow governments to reduce headline rates while broadening the tax base. Such has been the pattern of many recent tax reforms that have aimed to attract direct investment by multinationals, prompting Stephen Bond of the Institute for Fiscal Studies to suggest that the tide of history is moving in favour of this option.
The difficulty here is in the transition. Businesses that built their capital stru
cture on the basis of interest deductability will lobby ferociously to prevent such a change, especially in private equity, where profits mainly come from financial engineering, not enhancing underlying performance. Even a move to eliminate deductability only on new debt would be politically contentious. Yet the Germans succeeded in the face of heavy lobbying in limiting interest deductability in their corporate tax reform of 2008.
In the US, where the Treasury floated the idea of limiting interest deductability in 1992 without attracting much political support, tax reform is creeping back on to the agenda as the President’s Economic Recovery Advisory Board under Paul Volcker, the former chairman of the Federal Reserve, works on options for reform. The deductability issue applies to consumers too since mortgage interest still attracts tax relief. While the political climate is different from 1992, the lobbying power of business and the banks remains strong. So reform of corporate taxes could be an intractable task.
In the UK, there are few signs that the Labour government is interested in the issue. The Conservatives, by contrast, have been preoccupied since the Thatcherite 1980s with fiscal neutrality. This doctrine, of which Bank of England governor Mervyn King was an early advocate, asserts that tax should not unnecessarily influence saving and spending decisions.
George Osborne, Tory shadow chancellor, has committed his party to reducing the headline rate of corporation tax and reducing reliefs. Last summer he floated the idea of restricting interest deductability on new debt. Yet he faced a barrage of criticism from industrialists and from private equity. Mark Hoban, shadow financial secretary, now says any move should be “consultative and deliberative”, which sounds the very definition of the fiscal back burner. And there remain wider concerns about introducing a fundamental reform unilaterally, which could cause internationally mobile investments to head elsewhere.
Yet a failure to address this very large distortion, which affects most of the larger developed economies, means the tax system is at odds with policy initiatives that seek to promote financial stability. It is a fundamental and destabilising flaw in the post-crisis financial architecture.
The writer is an FT columnist
Copyright The Financial Times Limited 2010.
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