Effects on corporate finance
Poster Cesinco poses this question:
Oddly enough, you may find that one of the biggest obstacles [the FairTax will have] to overcome is from the corporations themselves, who would no longer have any corporate taxes to pay under the FairTax system. As [is pointed out in the FairTax books], many business decisions are made taking into consideration the tax consequence of those decisions. Chief among those is the decision of how to finance the corporation and whether that would be through debt, equity, or some mixture of the two. In fact, one of the jobs of the corporate finance guys is to find the ideal point between financing through debt and through equity such that the company employs its invested capital to the greatest potential.
Debt is cheaper to use partly because interest payments on debt can be deducted from the corporate tax payable, but there’s a limit to how much debt a company would dare issue because of the greater risk of defaulting on the debt payments, leading to eventual takeover by the bondholders. If there is no more corporate tax to pay, you remove one of the biggest incentives to finance the corporation through (cheaper) debt. Why should any company issue debt if there is no tax advantage to doing so, especially when the cost of default (loss of control of the company) is so high? To account for the possibility of loss of control, interest payments on debt would have to fall to the point where investors would not take interest in corporate bonds, opting instead for safer government bonds. The likely result is that the corporate bond market will dry up and corporations will choose to be funded entirely through equity.
Additionally, this would spell the end of leveraged buy outs such as the most recent sale of Chrysler to a private investor’s group because nobody in their right mind would want to issue that much debt in order to buy a company, if interest payments on that debt cannot later be deducted from a coporate tax.
Also, by removing the incentive to issue debt to debt holders, you create a moral hazard since equity holders do not have any legal recourse, as do bond holders, to take over the company’s management if the finances of the company are being mismanaged. This creates an incentive for company’s managers to make less than ideal decisions, knowing that they will not lose their jobs when the board of directors gets turfed out because of defaulting on their bond obligations.
How would the authors of the FairTax address this “problem”?
I am assuming the assertion here is that the tax code makes debt financing “cheaper”, and therefore removing that tax incentive will make financing a corporation through debt less desirable. That seems reasonable. If the assertion is that this will make debt financing obsolete, that is not correct. While the tax benefit is part of it, I’m sure it is not the only thing corporations consider, especially since the financing is still an expense, i.e. they are not making money from paying the interest. The interest is just not as much of a burden because of the tax write off. This is actually an economic distortion that should be removed. It is the same sort of distortion that occurs because I get to write off my mortgage interest. I was willing to pay so much per month based on my income. Since I got the write off, I discounted my mortgage payments on the write off. I was willing to pay more because of the government kick back. This is great for me, but people who also have a mortgage but can’t itemize have to pay more based on the fact that I’m willing to pay more.
Andrew,
I agree with you that this is an economic distortion but I don’t think you can compare corporate finance with personal finance. You are correct that from the taxation side, corporate and personal taxes are comparable since interest paid can be deducted from gross income. On the other hand, while I and the majority of taxpayers do not have a choice with how we raise our funds (we must work for a salary), corporations can choose to be funded either through debt or through equity.
What makes debt financing unattractive for corporations is that defaulting on interest payments allows the lender to take away the company’s assets (and in this way, corporate finance and home ownership truly are equivalent, as many Americans in foreclosure are discovering today). So, all else being equal, corporations would rather finance themselves through equity because of the inherent protection it affords them from creditors.
Take away the ability to deduct the interest payments from the corprate tax payable and you have effectively taken away the advantage that issuing debt had with respect to issuing stock - it was a cheaper form of financing the corporation. But since the debt holders would still have the right to take over the company’s assets in case of default, only the disadvantage remains.
Cesinco,
Maybe I am over simplifying the issue (or misunderstanding), but the tax write off for debt financing does not completely remove the cost compared to equity financing. It just reduces the cost, right? If so, that means there must be another advantage to debt financing other than the tax right off. That’s why I draw the conclusion that the amount of debt financing will be reduced under the fair tax, just not eliminated.
Andrew,
The only other advantage that debt financing would still hold over equity financing is that debt holders would demand a lower return on their investment than equity holders, since their investment carries with it the rights to take over the company if the company falters. Equity holders have no such legal recourse so they must be compensated for this greater risk with higher returns.
But this is my point too. Since debt would become a less attractive method of financing (due to not being able to deduct interest payments from tax payable), the company would want debt holders to accept an even lower return. And in the case of AAA-rated corporate debt, this may mean a reduction to the same rate that the US treasury pays on its bonds and notes. If so, why would investors choose this option when they could simply invest in the risk-free treasury and have the same return?
Cesinco,
I don’t disagree that in many cases the scenario you laid out will occur. But I think you have to agree that in some cases the bond rates will not go below the US treasury bond rate. That’s why I think the incentive to finance through debt will just be less, not totally eliminated.
Under the FairTax, state and local municipal bonds would lose their federal tax advantage. This might make corporate bonds more attractive.
Andrew,
If the corporate bond rate were ever to dip below the treasury rate, it would point to far more serious problems - essentially, we would implictly believe that a corporation has a lower risk of defaulting on its debt than the federal government. Considering that the federal government can raise taxes to pay its bond obligation while a corporation has no such means, makes this an absurd situation.
Morphh,
And that is one of the key reasons that the National Governors Association is totally opposed to any national sales tax. As Brad Rees pointed out, state bonds are already under attack from the IRS under the TEFRA Act of 1983(?). The Supreme Court majority opinion held that the legislation, which allowed the IRS to tax state bonds if they were not registered (bearer bonds), was constitutional. There is a major constitutional issue lurking out there, and I don’t think the feds will be allowed to tax state and local operations.
Cesinco,
I think you missed my point. You said, “And in the case of AAA-rated corporate debt, this may mean a reduction to the same rate that the US treasury pays on its bonds and notes.” This case you present does not represent 100% of the debt financing scenarios that can occur. It is only my assertion that higher yield bonds will still exist, and while I completely agree with the assertion that debt financing will be less attractive, it will not be made obsolete.
On a side note, maybe I shouldn’t have said below the US treasury rate, although I will point out that Moody’s has at least stated that it has considered lower the AAA bond rating for federal bonds. Our entitlement crisis is the reason for the consideration. I believe this is the third year in a row (maybe second) that the medicare trustee board was required to issue a warning based on the fact that we are within 7 years of more than 45% of medicare being paid for by general revenue. The president met his legal requirement to suggest a restructuring to address this issue, but the congress chose to do nothing.
Hi Andrew,
No - I did understand your point. My point is that if the spread between the Treasury rate and the corporate bond rate does not adequately compensate the investor for the increased risk (regardless of whether the corporate bond is rated AAA or junk), then the astute investor would choose not to buy the corporate bonds.
Suppose that if B-rated corporation represents a 5% risk of default above the Treasury rate (also supposing it to be 4%), then the corporate bond would have to return at least 9%. But if the corporation wants the investor to accept only 7% (still higher than the Treasury rate), the investor who buys such a bond is making a “bad bet”.
Don’t you think there is a more compelling reason than income tax for a business to issue debt rather equity? I was taught that business issued debt to leverage the operations, thereby making more money when profitable. Unfortunately, the business loses more money when unprofitzble and leveraged. That’s one of the problems our banking system is experiencing today. Many leveraged buyouts are turnig into losers.
In any case, a business will issue debt rather than equity when the business owners believe they can be profitable after servicing that debt. They keep the company for themselves rather than sharing it with other equity purchasers. While this is true for small companies like the local beverage store on the corner, it applies equally well to the big guys. The FAIR TAX would certainly not eliminate debt securities.
Going back to the original question. The Fair Tax book also argues that the cost of loans (the interest rates) would drop significantly compared to what they are today. It seems that as Andrew stated earlier that the write-off does not remove the cost of debt, but just reduces it, the result would be the same under the FairTax.
With repatriation of dollars to the US, the argument is that there will be lots of money available (not sitting in off-shore accounts) to be invested in business. With high availability of funds, the cost of those funds (interest rates) would go down.
As with cost of retail goods prices dropping as a result of the FairTax, so would interest rates and the cost of debt.