Systemic Financial Degradation Due to the Structure of Corporate Taxation

Mark J. Roe is the David Berg Professor of Law at Harvard Law School, and Michael Tröge is Professor of Finance at ESCP-Europe. This post is based on a recent article by Professors Roe and Tröge.

In our article, Systemic Financial Degradation Due to the Structure of Corporate Taxation, which was recently posted to SSRN, we examine how financial sector safety is undermined by the structure of the corporate tax. Regulators have sought since the 2008 financial crisis to strengthen the financial system. Yet a core source of weakness and an additional instrument for strengthening, namely the effect of the corporate tax on the choice between debt and equity, is hardly on the regulatory agenda. Current corporate tax rules allow firms to deduct the cost of debt but not the cost of equity. This penalty for equity encourages high levels of debt, lower levels of equity, and concomitantly riskier firms. But this not an inevitable property of taxation. Alternative tax schemes, that are either capital structure neutral or favor equity instead of debt, exist and have been successfully tested in other countries.

The corporate tax’s overall pro-debt bias is well-known, but less widely recognized is that this pro debt bias is particularly pernicious for financial firms, because corporate tax rules undermine the capital adequacy goals that have been central to the post-crisis reform agenda. Therefore, addressing this tax bias for financial firms is more urgent than correcting it for industrial firms: For industrial firms, the tax bias induces higher leverage but does not pose systemic problems; the debt bias for financial firms does. In addition, for industrial firms, the tax-induced preference for leverage has positive corporate governance effects, with debt often making managers and directors try harder and work smarter; for banks there is no comparable beneficial corporate governance undertow. Indeed, the extra debt encourages banks’ managers and boards to take on more risk, which degrades bank corporate governance and is just what regulators want the banks to avoid doing.

Corporate tax reform for financial institutions can yield a major regulatory strategy, but this alternative to traditional command and control regulation is largely unexamined, especially when compared to the deluge of proposals for additional command-and-control rules. Policymakers and academic analysts focus on the 2008-2009 crisis’s proximate causes—a housing bubble, poorly capitalized financial institutions, and a financial system that could not absorb losses in the real estate mortgage sector without general lending freezing up. But the preexisting levels of debt were higher than appropriate for safety due in large measure to the tax-based debt bias and only when fixing this problem can we expect financial institutions to substantially increase equity levels.

Calls for generalized business tax reform are on the table in the United States and around the world: U.S. presidential candidates have proposed to reduce or eliminate the pro-debt bias for non-financial corporations, but unfortunately these proposals generally exempt financial institutions. We argue that the opposite strategy makes more sense. The safety-undermining impact of the current corporate tax should be ended and, indeed, reversed with a tax reform targeted at regulated financial institutions such as commercial banks, investment banks, broker-dealers and insurance companies. General corporate tax reform to reduce or eliminate the debt-bias might be best solution, but it has thus far been elusive. In the spirit of seeking the doable, we show how an incremental, targeted tax reform can achieve a high portion of the safety-inducing goals of the comprehensive tax reform, but without the disruptions of economy-wide change that may be politically unattainable.

The best trade-off of goals and practical potential is to reduce the corporate income tax penalty on equity of financial institutions by according an imputed deduction for the cost of equity capital above the regulatory-required amount. The tax reduction generated by this “allowance for non-regulatory equity” would then be offset elsewhere, for example by taxing assets or the riskiest class of liabilities to obtain an overall revenue neutral tax reform. That offsetting tax rate can, we show, be quite low, because the typical American bank’s equity base is narrow and close to the minimum requirements. There is now enough international experience with these types of taxes to show that tax incentives do work here. Financial firms subject to these taxes will voluntarily lower debt and increase equity, rather than resisting further capital strengthening. The evidence, while imprecise and sometimes indirect (because no economy has the precise tax reform configuration we recommend) points to the magnitude for this tax-based improvement in equity levels that could well rival the size of all the post-crisis mandates to increase capital. This is thus not a small or technical claim we bring forward. Properly taxing banks is the next, and quite promising, regulatory frontier for financial safety.

The full article is available for download here.

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