LONDON (Reuters Breakingviews) - Excess corporate debt makes the global economy wobbly. After the pandemic, governments should use the tax system to encourage more equity and less leverage. That will help the economy resist future shocks. Countries may even be able to raise some cash to repair their own balance sheets.
The current economic crisis hasn’t been triggered by debt. That makes it different from the global financial crisis, which was spawned by an unholy cocktail of mortgage borrowing and financial sector leverage.
But companies’ gigantic borrowings are an underlying condition which will magnify the Covid-19 crisis in three ways. First, leveraged firms are more likely than well-capitalised ones to go bust and fire workers. Second, many companies will survive by taking on still more debt, which will make them weaker. Third, governments and central banks are having to bail out businesses, adding to their own liabilities and so making the public sector more fragile.
After the global financial crisis, a big effort was made to cut bank leverage. This was mainly done with regulations. But some countries, especially those in the European Union, also used taxes – so-called bank levies – to encourage lenders to use more equity and less debt.
But precious little has been done for non-banks. Not surprisingly, corporate debt around the world has kept going up. In the 12 years to the end of last year, borrowing by non-financial companies rose 70% to $74 trillion, according to the Institute of International Finance.
One reason for this is that the tax system incentivises debt. Interest payments are almost always deductible when calculating corporate taxes, whereas returns on equity rarely are. Private equity-backed companies have been particularly adept at exploiting this asymmetry.
Bailouts exacerbate the problem by creating moral hazard. True, some highly indebted companies are now struggling to get government-backed loans. The U.S. Federal Reserve’s “Main Street Lending Program” is restricted to companies whose debt is less than 6 times last year’s “adjusted” EBITDA, and the EU prevents state aid to companies that were in difficulty before the start of this year.
But the Fed is now buying junk bonds. As a result, the extra yield investors demand to hold U.S. junk debt rather than U.S. government bonds has almost halved from its peak on March 23, according to an ICE Bank of America index.
If the cavalry rides to the rescue whenever there is trouble, it is rational for companies to keep leveraging themselves up to the gills. But that’s not sensible for society as a whole, because it makes the global economy more vulnerable to shocks.
We are witnessing what economists call an externality, where a private agent foists some of the costs of its behaviour onto the community at large. It is a type of financial pollution.
As the International Monetary Fund wrote in 2016: “Excess private sector debt can be seen as a systemic credit externality”. It cited academic research that job cuts were “significantly more pronounced” in highly leveraged firms and that the build-up of debt made recessions “more likely, deeper and longer lasting.”
A classic remedy for an externality is a “Pigouvian” tax, named after the economist Arthur Pigou. This discourages undesirable behaviour. In this case, there are broadly two ways to level the playing field between debt and equity. One is to make debt less attractive by stopping the tax deductibility of interest payments. The other is to make equity more attractive by allowing an equivalent deduction via an “allowance for corporate equity” (ACE).
Over the years, countries have experimented with both approaches. Italy has an ACE scheme, while America has limited the tax deductibility of interest to 30% of EBITDA. The EU has done something a bit similar for intra-company loans, to discourage multinationals from shifting debt to subsidiaries in high-tax countries.
The ACE approach has the advantage that it cuts the cost of capital and so encourages investment. The snag is that governments won’t be able to afford to give companies extra tax breaks after the pandemic.
Stopping interest deductibility has the opposite benefits and disadvantages. Removing the tax shield from interest on $74 trillion of corporate debt should raise hundreds of billions of dollars a year in extra fiscal revenue. The problem is that this would push up the cost of capital and deter investment.
There are, though, ways of squaring the circle. One would be to allow companies to deduct capital spending in the year it is made, rather than depreciating it over several years for tax purposes. If this was combined with stopping interest deductibility, firms might still have an incentive to increase their investment. That could be especially valuable given that the world will soon need an investment-led recovery.
Whatever is done, changes should be phased in over several years. International coordination would also be beneficial.
Economists have, of course, known for decades that the tax system is skewed in favour of debt, and nothing much has happened. Why should things be any different this time?
Well, it’s not quite true that nothing has happened over the years. After all, bank leverage was reined in after Lehman Brothers went bust. What’s more, governments are soon going to be looking into every nook and cranny for opportunities to raise tax.
One of the buzzwords of the moment is “resilience”. Weaning companies off borrowing would help achieve that goal. If governments miss this opportunity, debt will just spiral away upwards – and when the next shock hits, the world will be in another fine old mess.
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