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E-MailIvo Welch is the J. Fred Weston Chair in Finance and Distinguished Professor of Finance at UCLA.
It is hard to imagine a financial crisis that is not ultimately caused by creditors who had taken on too much debt. Debt is the root cause of most corporate financial failures and, if a snowball effect sets in, the root cause of financial system failure. Of course, debt also has advantages. Without debt, many privately and socially valuable projects could never be undertaken. Still, it is our current tax system that has pushed our economy to be too levered. Now is the time to address the problem—before it will again be too late.
From a creditor’s perspective, the two key advantages of debt are the tax deductibility of interest payments and the ability of lenders to foreclose on non-performing borrowers (which makes it in their interest to extend credit to begin with). Although both factors contribute greatly to the incentives of the borrower to take on debt, there is one important difference between them: the tax deductibility of debt is not socially valuable.
To explain this issue, let’s abstract away from the beneficial real effects of debt and consider only the tax component. In an ideal world, taxes should not change the decisions of borrowers and lenders. They would take exactly the same projects and the same financing that they would take on in the absence of taxes. At first glance, one might argue that the tax distortions of leverage are not so bad, because the interest deductibility of the borrower is offset by the interest taxation of the lender. But this “wash argument” is wrong. It ignores the fact that capitalist markets are really good at allocating goods to their best use. In this case, it means that the economy will develop in ways that many lenders end up being in low tax brackets (such as pension funds or foreign holders) ,while many borrowers end up being in high tax brackets (such as high-income households or corporations). The end result will be not only that the aggregate tax income is negative, but that debt is taken on by borrowed primarily to reduce income taxes and not because debt has a socially productive value.
What then can we do to improve our social outcome? The answer is simple: eliminate both the tax deductibility of interest and the taxation of interest income. The net effect would be an increase in governmental tax receipts. (Incidentally, because the US has become a net world debtor, much of the interest income was already untaxed, anyway.) Taxes were paid disproportionally by senior citizens who depended on this income. Politically, they would provide a natural base of support for such a tax proposal. Of course, existing highly indebted corporations [like banks and LBOs] would lobby heavily against such a proposal. Long-term, seniors would accept lower interest rates, creditors would pay lower interest rates (though not after taking the interest deductibility into account), and tax receipts would be higher. The increased debt receipts could be used to reduce the deficit or income taxes.
However, there is a second important social cost of debt. It arises from contagion effects. Borrowers and lenders are not likely to be fully aware of or considerate of the effects that their own failures could force onto other firms. Thus, if a few large firms fail, especially if a few large banks fail, it could further restrict credit and force other firms to fail in turn. The result would be a potentially catastrophic downward spiral of the kind of which we had a good taste in 2008. It was bad—but it could be worse.
This “contagion externality” suggests we should discourage debt even more than what I already argued we should discourage debt due to the tax distortion. We may want to deliberately disadvantage debt. The easy way to do this would be to retain the taxation of interest income, but eliminate the tax deductibility of interest payments. This would discourage debt as a method of financing, and put it on more equal ground with equity. After all, we do not allow borrowers like firms to deduct dividend payments, and yet we still tax dividend and capital gains receipts. Frankly, the current tax system that favors debt over equity is not only logically absurd, it is also socially harmful.
An intermediate proposal to deal with the contagion risk of leverage would be to divide debt into a component that is safe and a component that is unsafe. This is surprisingly easy to do. If a corporate bond pays 6% while the comparable Treasury bond pays 2%, then the unsafe component is worth 4%. We could then allow firms to deduct interest payments of only 2%, not the full 6%. This would discourage firms and banks to take on debt that is so risky that it has a significant impact on the paid interest rates—and so risky that it can take down the firm. It would especially discourage LBOs. These highly levered firms have often taken on debt that is so risky that it could almost be called equity. The tax deductibility in these buyouts if often a major source of gains that accrue to the owners (but not society). Again, it is absurd that we use the tax code to encourage LBOs. This is not to say that all LBOs are bad. But we only want LBOs that are taken on because they make firms run more efficiently, not because they shelter more taxes.
Of course, there are some difficulties in implementing this tax change, too. First, I have ignored liquidity premia in corporate bond rates. We could live with the fact that we may discourage leverage too much (my preference), or we could offer an arbitrary modest additional premium allowance (say 100 basis points), or we could use some unusually illiquid government bond instead of the liquid Treasury. Second, I have ignored other features in bonds, such as equity kickers in convertible bonds that drive down the paid interest rate, or zero-coupon bonds that delay payment. This would require reasonable tax regulations and valuation methodologies—of the type that corporations already have to produce for the IRS today to deal with the very same issue of complex tax arbitrage.
Of course, no rule is perfect. But reducing the tax deductibility of interest only to the part of interest that is “safe” is a step in the right direction.
2 Comments
Professor Welch , this was a very interesting article and triggered a number of thoughts.
Was wondering whether the US Government draws up an annual Profit and Loss Statement, a statement of financial position (Balance Sheet) and a Cash Flow Statement? The reason I am asking this is because an analysis of debt as done above is incomplete without understanding the complete balance sheet in terms of assets. In addition, the importance of cash flows in the running of a business or government should not be underestimated. If a proper Cash Flow Statement is prepared in terms of Cash Flow from Operations, Cash Flow from Investing Activities and Cash Flow from Financing Activities it may be very useful and give us insights about sources of cash and uses of cash and what needs to be done to manage finance better and make the balance sheet strong once again.
I am sure the Congressional Budget Office (CBO) must be preparing detailed plans and would be crunching the numbers for government expenditures for various programs (existing and future). I am confident that this exercise would have resulted in a pro-forma P&L, Balance Sheet and Cash Flows.
These would include the sources of funds and uses of funds for the various programs. Sources of funds are revenues coming into the Government’s treasury to fund these desirable social and other programs. Use of funds is the actual expenditure plans for these chosen programs. From a Cash Flow perspective one cannot fund programs for which one does not have cash without either borrowing it or printing more money. Printing more money means debasing the currency. Borrowing more money means additional Interest Payments.
The Primary source of Government Revenues is Tax receipts from individuals and corporate organizations. In a given year, when these receipts are lower than the expenditures incurred on various government programs we finance these shortfalls by either borrowing the money from those willing to lend or print money to cover the shortfall. This practice of deficit financing which does not result in wealth creation, building of future productive capacity/capability and continuing productivity improvements for the short , medium or long term means that you are throwing good money after bad.
So what are the options before the US Government for managing its finances?
(1) Comprehensive Tax Reforms. – Scrap all existing deductions and loopholes and maintain existing tax rates – (which are anyway quite high) at the levels they were at during Bill Clinton’s administration which was the only time in recent memory when the US created 23 million jobs and had a surplus budget. Do not use tax policy as an incentive for anything going forward.
(2) Ensure that all expenditure plans currently being incurred by the government for its various programs are examined with a magnifying glass for actual social benefit as a result of these programs, and all unnecessary expenditures/programs are curtailed. Incentivize this cost control by rewarding the actual Bureaucrats with variable compensation directly linked to the savings/cuts in expenditures achieved.
(3) Pass a law that the first four months of all government annual tax receipts will go towards reduction of debt currently existing in the books.
(4) Pass laws that align entitlement spending on Medicare and Social Security to protect the neediest in society and ensure that retirement age as well as eligibility requirements for these programs are extended in line with increasing life expectancy globally. This is a critical requirement to ensure the viability of these social programs for future retirees and sustain the benefits of the Great Society experiment era.
(5) Ensure that Annual Cash Receipts are at least 5% greater than Cash Expenditures on a sustained basis for the next three decades so that the US Government Balance Sheet becomes stronger in the long-term and the US Moves from being the largest debtor nation in the world to the world’s largest creditor nation.
(6) Manage Cash Flows judiciously. This is the most critical element of Financial Stability Management. Cash Flow from Operations should be the primary source of funding for all Government Programs. Cash flow from financing activities by additional borrowings needs to be shunned till the US Government Balance Sheet gains strength. This extremely critical as borrowing costs today are at historic lows and in a scenario where borrowing costs go up by even 100 basis points the interest costs would eat up all of the Government Receipts in the future. This scenario is not too far-fetched as already more than 50% of all external borrowings are from China. For the short-term the US may need to borrow additional funds to tide over cash crunch requirements for the approved government programs and ensure that it does not default on its interest payments. These cash flow issues need to be resolved expeditiously so that the cash expenditures as a result of additional financing to fund government programs are minimized and eliminated. This implies that growth in government expenditures needs to be minimized and if possible reduced as borrowing from China to fund the profligacy of Government Programs is not a long-term sustainable strategy. Cash flows from Investing activities also needs to be monitored with a Hawkeye and minimized as many of these Government sponsored programs could be implemented much more efficiently in the private sector with profit motive being the driver for such programs. Other than creating infrastructure for the private sector organizations to flourish the Government should keep its nose clean and use incentives to attract investments which will create future industries and jobs.
(7) Finally, your article has triggered the thought about the capital structure in the Government Balance Sheet. Can we think the unthinkable and would it be possible to buy Equity in the US Government? Currently US Government Treasury rates are at historical lows and it is possible to borrow at these low rates and retire debt at higher rates. But, this state of affairs may not continue in the foreseeable future. By Issuing Equity in US Government (IPO) a lot of existing Debt Holders in US Treasury could get the option of converting their existing Debt into Equity and instead of measly interest payments they could get Dividends and help fix the US Debt Problem. By making such Dividend Tax Free the IPO in US Government Equity could be made very attractive for both US Residents and Foreign Governments Holding US Treasury. Many US Residents and Foreign Governments would be willing to bet on the future success of USA and be willing to subscribe to this IPO at a reasonable premium.
Some of these suggestions may seem naive, radical and politically difficult — but difficult times call for different ways of approaching the problem and seeking solutions. Hope, some of these suggestions are interesting and triggers further discussions.
Maybe other Governments in Europe who have Soverign Debt Problems Could look at Soverign Equity Issues as a possible option for addressing their borrowing problems?
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