Debates on the corporate tax are mostly about “how much"—not about “how.” The debate over recent corporate tax plans is no exception. Congress moves tax rates up or down, but the structural imbalances that have built up in the U.S. tax code because of the “how” are ignored. When Sen. Kyrsten Sinema (D-Ariz.) opposed any rise in the corporate tax rate, talk turned to other tax possibilities. With the budget scoring indicating that better enforcement and auditing will not produce the predicted bonanza, corporate tax reform may well come back into focus.
Tax Policy Favors Debt
If it does—and it will eventually, even if not in this go-around—there’s more to say about the corporate tax beyond whether the rate should go up or down. By sharply favoring debt over equity, the U.S. corporate tax does considerable economic damage.
For large companies, debt and equity are alternative ways of raising outside funds. But one way is tax-advantaged: Interest on debt is tax deductible, whereas dividends are not.
This incentivizes companies to carry more debt than is healthy. And it disadvantages small businesses and innovative companies that cannot get the debt-based tax benefit because they cannot borrow as easily.
Nonfinancial firms are using more and more debt. In 1970, nonfinancial corporations financed about one-quarter of their assets with debt. Fifty years later, this doubled to half coming from debt. The corporate tax is not the only reason for this trend—other taxes, the size of government debt, and the Fed’s interest rate policy are important—but the corporate tax is vital to the story.
The effects of higher-than-needed corporate debt are insidious because it surreptitiously renders companies more brittle and makes the economy more fragile. It degrades companies’ strategies by making them more rigid and less able to move fast.
Debt Bias in the Tax Code
The debt bias from the tax code has not gone unnoticed. The 2017 tax bill clumsily sought to control it, by capping interest deductibility at 30% of operating income. This penalizes firms that operationally must use high levels of debt, such as firms that use debt to finance inventory. Some of these firms, such as car and other dealerships, obtained arbitrary tax exemptions that allow them to deduct all of their “floor plan financing interest,” even if that interest amounts to more than 30% of operating income.
But businesses with less political clout did not do as well. True, with interest rates currently so low, the 30% of income cap catches few firms. But as interest rates rise, which seems to be in the cards for 2022, more companies will pay more interest and bump into these caps, leading them to distort their financing and operating decisions and then to ask for, and get, exceptions to the cap if their industries have enough clout with Congress.
There’s a better way that has been well-discussed by academics, successfully tried in several nations, and might soon be implemented across the European Union: The cost of equity could be made tax deductible in the same way as is the cost of debt. This approach, called “Allowance for Corporate Equity"—or ACE—usually fixes a tax-deductible cost to equity based on government bond rates. While this doesn’t capture the full cost of equity for risky companies, it makes companies just about tax-indifferent between debt and equity.
True, this basic “ACE” would lower the corporate tax bill—by increasing the deductions—if nothing else were done. But the corporate tax rate could then be re-set to pull the same number of dollars from the corporate sector. How much corporations should pay is a separate issue. Whatever level policymakers seek can be done via an ACE.
The bottom-line advantage—and it’s a big one—would be that the corporate tax would no longer incentivize large corporations to build risky, debt-heavy balance sheets. If the EU goes forward with proposals to use an ACE, the U.S. will find itself at a financial disadvantage. Firms react to international tax differences and the result—such as an ACE in the EU but not in the U.S.—would be for unhealthy debt to migrate to the U.S. and healthy equity to be more robust in the EU.
ACEs work. In countries that introduced an ACE, companies decreased leverage and increased investment. Our research—in which we aggregated every study worldwide analyzing how firms adjust their capital structure in reaction to changes in the corporate tax—points to an ACE as likely to induce the US corporate sector to have $10 less debt for every $100 of outside capital. That is, a firm that today, at the current tax rate, has $40 of debt for every $60 of equity would have $30 of debt and $70 of equity, even with the ACE taking the same number of dollars out from the corporate sector. While this is not much for any individual company, it would make businesses throughout the economy more stable, reduce the size of the debt-based financial sector, and reduce corporate financial distress. For some sectors, such as banking, that increase in equity would be particularly valuable. An ACE would encourage banks to take on more equity and would reduce the likelihood of a repeat of the 2009 financial crisis, which would have been much less severe had the financial sector then been using more equity and less debt.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Mark Roe is a law professor at Harvard University. Michael Troege is a professor of finance at ESCP—Business School.
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