Waiting for a friend in a downtown skyscraper the other day, I pulled a corporate finance text off her shelf to refresh my memory about why companies borrow money rather than allowing individual shareholders, if they want a higher-risk investment, to borrow money on their own and purchase shares with leverage. The book covered the Modigliani-Miller Theorem, a 1958 result showing that borrowing money doesn’t help a company’s managers or shareholders… in a world free of corporate taxes. Given a corporate income tax and deductible interest, however, a company can significantly improve its performance by borrowing.
The U.S. has some of the world’s highest corporate taxes (source) and we’ve also had a lot of leverage (Wikipedia says that private equity is more than twice as big in the U.S. than in Europe despite comparable economy sizes). The leverage made the Collapse of 2008-? a lot more painful than it would have been without the leverage (or maybe the collapse wouldn’t have happened at all).
Has anyone heard a public debate on this subject? I.e., whether or not our tax code substantially increases the risk of corporate bankruptcies by encouraging leverage?
Icelandic banks took on enormous amounts of debt yet their corporate income tax was only 18% as of 2002. Other countries which dodged the Collapse include Canada (38.6%), Germany (38.4%) and New Zealand (33%) [all per your Cato source].
To actually answer your question it looks like the answer is, no. Probably only the Cato/Heritage/AEI type thinktanks are pushing this line (see another example here with a more up-to-date chart: http://www.heritage.org/research/taxes/bg2248.cfm)
R: Thanks for the link to the Heritage article. I think it reinforces my point that nobody is talking about leverage. They do mention the effect of corporate taxation on leverage, but way down in a technical appendix. The article aims to be an exhaustive list of all the things that are bad about corporate taxes, yet nowhere does it argue that leaving investors to take on leverage for themselves would have resulted in greater economic stability.
You’re right, but at best it’s a fairly minor effect.
The optimal leverage for a firm varies wildly by industry, interest rates, the jurisdictional costs of bankruptcy, agency costs (i.e. the incentives of the management), availability of tax shields, etc.
One reason tax rates represent a minor effect is that the value of the interest tax shield changes with the tax code and is therefore unpredictable over the life of a typical corporate bond. In the US, it has varied greatly in the last 40 years:
1970: 18%
1980: 8%
1990: 34%
2000: 25%
2010: 18%
Note that during the bubble, the value of the interest tax shield dropped and companies piled on the debt anyway. The tax effect was outweighed by other factors, mainly low interest rates and skewed incentives.
For the technically minded: the optimal level of leverage is the amount where the interest equals EBIT (Note that EBIT is hard to predict). If you go beyond this point, the so-called costs of financial distress kick in, and the value of the firm drops. Since top management tend to have incentives that are stock-based, most real-world firms are actually under-levered compared to theory – usually between 30-50% of the “optimal” amount.
The value of the tax shield (T*) is calculated by relating the corporate tax rate (Tc) with the tax rate on interest (Ti) and the tax rate on equity (Te):
T* = 1 – ((1-Tc)*(1-Te)) / (1-Ti)
If you manipulate the variables correctly (high Ti and low Tc & Te) you can relatively easily create a tax *disadvantage* for debt.
Weren’t recent events exacerbated by *both* leverage and personal borrowing (against inflated assets) to invest?
Scott: Obvious the tax code had a huge effect on personal borrowing as well, by making mortgage interest deductible the government encouraged folks to take every possible dime of equity out of their houses. I did not mean to imply that high corporate taxes were the only factor in the Collapse of 2008, just wondering why I hadn’t seen any discussion of them given that classical Econ would say that encourage nearly unlimited corporate leverage.
“The book covered the Modigliani-Miller Theorem, a 1958 result showing that borrowing money doesn’t help a company’s managers or shareholders…”
Er, I think you have this one backwards. According to the Wikipedia article, the theorem (the “capital structure irrelevance principle”) is used to justify borrowing rather than issuing more equity, under the theory that debt and equity are equivalent.
Borrowing money can certainly help a company’s managers: by increasing leverage and risk, they can make a large “heads I win, tails you lose” bet. If they win the bet, they get large salaries and bonuses; if they lose, they walk away, and the shareholders take the loss.
Don’t forget the impact of FFR on appetite for leverage. Nobody is going to retire on 1% returns. By keeping the FFR so low, our genius fed overlords are forcing money into risky assets, and requiring leverage to achieve modest returns.
It seems reasonably clear to me that the Fed response to the ’01 recession was the fertilizer for the leveraged housing bubble.
Maybe if the powers that be stopped trying to micro-manage the business cycle, they would stop providing perverse incentives to mis-allocate capital.
Leveraging is an old concept and has had a lot of use in our dealings with things material.
So, the question might be considered from this framework: is money material? Of course, it has observable (thereby, measurable) impact, as we see from the heights of the Brahmins to lowering floor of increasing unemployed set (which would include those under-employed – to wit, for one, the lost generation of Japan).
Except, given the current schemes related to money, a lot of it is nothing more than a mere fantasy, some promise for future payment, unfortunately with increasing uncertainty about risk (pun).
The trouble is that ‘leveraging’ has (been allowed to) become the, almost exclusive, tool for those who want to have unlimited accumulation of money which is more some mere book entry than anything real. Politicos are now even being upfront with their interest in money (Obama set this precedence more firmly with his gigantic coffer); the Supreme Court bowed to money recently with its bestowing of person-hood (in the sense of being covered by the concepts laid down a couple hundred years ago) on corporations. The news media fawn over those who have succeeded at the accumulation game.
Fundamentally, though, ‘money’ is a leverage which grounds an economic system. That which is of interest here is some mania that has gone way too far for several reasons that are of concern.
Hyman Minsky’s (Harvard) thoughts about speculation apply here. Some leveraging is okay; what amount is sustainable and healthy?
Hopefully, the web, and its tools, can be used to discuss these issues in the necessary autodidactic manner since all ‘institutions’ seem to have been drawn into a collective psychosis (including Harvard).
Thanks, Phil, for asking the right questions.
Phil,
When you stated that: “the tax code had a huge effect on personal borrowing as well, by making mortgage interest deductible the government encouraged folks to take every possible dime of equity out of their houses…” I must disagree. A tax deduction doesn’t encourage borrowers to take out all of their home’s equity.
While it may make it more convenient, i.e. “I’m gonna use my home’s
equity line to buy that new Lexus I’ve always wanted, since the interest is
tax deductible…” it doesn’t encourage me to borrow every dime I can
against the equity line. That’s the consumer’s fault for not having a shred
of discipline. The tax deduction for home equity lines (up to one million dollars, I believe) has allowed folks to borrow more efficiently, but it’s the consumers themselves who lost all touch with reality when they went out
and borrowed for stuff that depreciates in value from day one.
There is a huge difference between a deduction and a credit.