A recent IMF study is only the latest to show that the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. (CIT) contains a bias in favor of debt-financing, which could have been a contributing factor in the financial crisis. The CIT contains a bias by allowing taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. deductions for interest payments on debt, but not for corresponding deductions for payments to equity holders. This results in a virtual subsidy for excessive borrowing, leading directly to instability because companies are encouraged to become highly leveraged to maximize income tax deductions. As companies make more aggressive investments with more and more leverage, it makes them more vulnerable to economic downturns, as we saw with this crisis.
The current tax code distorts economic decisions through deductions that many companies capitalize on. This in turn can lead to a highly unstable financial situation and moral hazard. How big are the tax incentives to finance using debt? With a high corporate income tax rate like the United States’, being able to deduct debt interest payments is a significant incentive. The report states:
Between 2003 and 2006, the amount raised by private equity funds, which arrange most [leveraged buyouts], increased about five-fold, to around US$230 billion; and between 2000 and 2007 their share of merger and acquisition activity in the U.S. rose from 3 to nearly 30 percent.” (page 4)
The IMF notes that the required rate that the corporation needs to earn to finance borrowing is significantly less than the rate needed to finance equity, even for taxpayers who pay the highest rates (page 8). The IMF concluded that corporate debt-financing under the U.S. tax code is the equivalent of a 46% subsidy, while equity-financing is equivalent to a 24% tax (page 10). Other studies cited have shown that “a 10-point increase in the [corporate income tax] rate increases the debt-asset ratio by 1.4 to 4.6 points. As a rough order of magnitude, the debt bias from a [corporate income tax] at 20 percent (ignoring personal taxes) would then be to increase a debt-equity ratio that would otherwise be 40 percent, to 45 or 60 percent” (page 9). In other words, the combination of a high corporate tax rate and the debt bias results in enormous pressure on corporations to become highly leveraged, exactly the risky behavior that contributed to the financial crisis.
The IMF proposed some corporate tax reforms, both politically feasible and effective. Generally, they recommend moving toward more neutrality:
- Trying to eliminate interest payment deductibility after a certain level to keep it from being excessive.
- Making a comprhensive business income tax (CBTI) that would eliminate interest payment deductibility altogether.
- Use cash-flow forms of corporate income tax so that upfront the investment would be deducted in full (not depreciated over time) but not the interest payments.
Another option is to create the Allowance for Corporate Equity (ACE), which allows corporations to deduct interest on debt but also their return to equity, thus making the ACE neutral and restoring the debt-equity ratio. This may be politically unpopular because it could reduce government revenues and gives the mistaken impression that corporate income is not being taxed. Croatia, which adopted this system, severely narrowed its tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. , hurting government revenues. Raising the tax rate to make up for lost tax revenue would also encounter political difficulties.
One unanswered question is why these long-standing biases in the corporate income tax only now seem to have contributed to an overleveraged-related financial crisis. Whether it was the development and misuse of complex financial instruments, the highly leveraged positions of companies, the opaque nature of the financial system, the corporate income tax system debt-bias, or a combination of all of these factors is up for debate, but issues need to be addressed for the future. Changing the incentive structure for businesses could make a big difference, making the corporate income tax more neutral and promoting an even playing field between risky debt-financing and safer equity-financing.Share