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Debt BiasConceptual Analysis of the Issue

EC – IMF Conference on Corporate Debt Bias23 – 24 February 2015 – Brussels

Ruud de Mooij

Views are authors’ alone, and should not be attributed to the IMF, its Executive Boards, or its management

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Corporate debt bias

What is the issue? How big is the bias? Why do we have a bias? Should we care? Policy options

Specifics of debt bias in the financial sector

How different is it? Should we care more? Policy options

Outline

Two distinct issues

Bias in corporate financial structures Multinational debt shifting

Debt Bias

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Corporate Level Personal Level

Debt Tax deductible for CIT

1. Exempt2. Taxable at PIT

Equity Not tax deductible for CIT

1. Exempt2. Taxable at PIT:

- dividend tax- capital gains tax

Bias in corporate financial structures

Cost of Capital Debt versus Equity

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PIT Exempt Investor PIT Taxed Investor (top PIT)

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Parent (home)

Subsidiary(host)

Debt Interest taxable at home-country CIT

Interest deductible

Equity Dividend exempt(most EU countries)

Profit taxable at host-country CIT

Multinational Debt Shifting

Coefficient of variation in CIT rates

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How big is effect on

corporate financial structures?

Debt Bias

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Multinational Debt Shifting

9Source: Hebous and Ruf (2015)

Studies usually estimate D/A = α+βτ+γX+e Variation in τ over time, among firms within a

country, or cross-country variation Usually for non-financial firms only Both internal and external debt

Summary of 19 studies; 267 estimates Most report marginal effect of τ on D/A (=β) Elasticity better comparable ε = d ㏑ (D/A)/d τα

R.A. de Mooij, The Tax Elasticity of Corporate Debt: A Synthesis of Size and Variations, IMF WP 11/95

Empirical literature debt bias / debt shifting

Summary of empirical findings

Consensus of marginal impact coefficient is 0.28, i.e. raising CIT rate by 10 pt will increase debt/asset ratio by 2.8 pt, e.g. from 50 to 52.8

Effect increasing over time, e.g. effect today is 50 percent larger than in mid 1990s

Response of intracompany debt not significantly different from external debt

Main findings of literature

Why do we have a bias?

Accounting Administrative

Legal Economic

Debt Bias

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Interest on debt is seen as genuine cost of doing business – deductible from income

Equity returns are no business costs, but reward for owner – should not be deductible

Intracompany debt: under separate accounting, for each transaction within a MNC there is an equivalent external – ‘arms length’

It’s the accountants’ fault!

One could tax corporate returns at individual Interest: taxed at PIT – deductible for CIT Dividends: taxed at PIT – imputation of CIT Capital gains: can be taxed at PIT, but …

CIT administratively appealing as WHT, yet … … imputation systems disappeared … internationalization breaks links

Administration: why CIT in the first place?

Debt … … yields fixed return … has limited maturity … has prior claim … has no voting right

Legal: what distinguishes debt from equity?

But … No dichotomy between debt – equity: hybrids blur

distinction –demarcation rules vary Intracompany debt – is there any difference

between debt holder and equity owner?

Equity … … yields variable return … has unlimited maturity … has residual claim … gives voting right

Modigliani-Miller Firm value independent of debt/equity ratio – no

unique optimal choice of debt Imperfect capital markets

Information asymmetries: bankruptcy cost, agency costs; signaling debt bias raises risk premia

Imperfections in debt markets might be worse than in equity markets?

Debt might be more/less mobile than equity? No general ‘direction’ for the required correction in

second-best

Economic: theory of second best

Discrimination between debt and equity originate from accounting principles, but …

… have no administrative appeal – on the contrary

… have an increasingly problematic legal base – hybrids

… induces significant arbitrage risks … have no clear economic rationale –

perhaps the opposite (too high risk premia)

Summing up

Should we care?

Debt Bias

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Using trade-off theories ‘Triangles’ might be small – Weichenrieder-

Klautke (2008); Sorenson (2014)

Externalities can magnify them – rectangles Business cycle – magnify shocks Externalities of excess debt Financial Sector Arbitrage – administration and compliance

Welfare costs of debt bias

Policy Options

Treat all returns as we currently treat equity Treat all returns as we currently treat debt

Debt Bias

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Deny interest deductibility Consistent with comprehensive income tax Base-broadening allows for rate reduction

Problems & complexities Higher cost of capital Requires special regime for banks International mismatches Transitional regime for pre-existing debt

Comprehensive Business Income Tax

Deny deductibility of certain types of interest Arm’s length Thin cap rule (TCR) – D/E ratio Earning stripping rule – interest cap

Do not generally address debt bias 2/3 of all TCRs apply to internal debt only Usually a (very) high threshold Often do not apply to financial sector

Restrictions to mitigate debt shifting

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Neutrality properties Consumption tax – neutral to investment Neutral to debt/equity; depreciation rules

Practically feasible Experiences in Croatia, Austria, Italy Now operational in Brazil, Belgium, Italy

Potentially costly 10 – 15 percent of CIT revenue of full ACE, but …

… not in short-run if incremental (Italy)

… not in long-run if economic benefits are large

ACE –the love baby in public finance

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Base of the ACE

Initial equity base: zero (BEL) or base year (ITA)

+ taxable profit － CIT payable

+ dividends received － dividends paid

+ net new equity issues

+ net revenue from sale/purchase of shares in other companies

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Rate of the ACE

(risk-free rate of return)

ACE – Design

How different is it?

Should we care more?

Policy options

Debt Bias in the Financial Sector

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How different is it?

Debt Bias in the Financial Sector

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M. Keen & Ruud de Mooij, 2015, Debt, Taxes and

Banks, JMCB (forthcoming)

Banks face regulatory capital requirement

Hybrids are particularly important for banks

Banks enjoy (implicit) insurance

Yet

Banks generally hold buffers well above

regulatory minima: room for tax bias

Banks may already exploit hybrids fully

Unclear how corporate governance affected

How different do we expect banks to be?

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Response average bank ≈ average non-bank

But:

Effect is on hybrid debt negligible

Response banks with higher buffers bigger

Response by largest banks is smaller (Fig)

MNC banks shift debt to low-tax affiliates

Should we care (more) about all this?

Findings from (small) recent literature

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Empirical findings – banks of different size

Source: Jost H. Heckemeyer and Ruud A. de Mooij (2014)

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R.A. de Mooij, M. Keen and M. Orihara, 2014, Taxation,

Bank Leverage and Financial Crisis, Volume MIT Press

Three-stage estimate of the macro-economic

cost of debt bias in financial sector

1. Impact of bias on aggregate bank leverage

2. Impact of average bank leverage on

probability of financial crisis (highly non-

linear – see Fig)

3. Impact of crisis on GDP / Public debt

Should we care more?

Social cost of debt bias in financial sector

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… on taxation and bank behavior

E.g. MNC choice of subsidiaries vs branches

Why does size matter?

Importance of shadow banks

… on taxation and financial stability

Small response – big effects?

Hybrids – effects on risk?

Interaction regulation – taxation

Cross-border spillovers of taxation

But a lots of unknowns still …

Policy Options ?

Bank levies – EU experiences Thin-cap / regulatory cap

ACE for banks – e.g. UK debate Radical reform: CBIT; R+F base

Debt Bias

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