May
Debt vs. Equity – A Tax Bias?
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Given that I am not working these days, a lot of my time is spent on the internet. During my daily visit to seekingalpha.com, a question popped into my head – Has the historical preferential tax treatment for debt led (in part) to the mess we face today?
My argument is as follows. Debt and equity (and the various greys between them that have been so popular lately) perform the same essential function, i.e. provide capital for businesses that can deploy it profitably. Interest payments which are the investors’ reward for taking on the business’ risk. Since these are considered as a business expense, these are tax deductible. However, dividends which also reward investors for their risk appetite are taxed. Often, as is the case in India and the US, they are taxed twice – once when the business pays out the dividend and again as part of the shareholder’s personal income.
This differential tax treatment means that over a period of time, a strong preference for debt rather than equity has emerged. And this has in turn, led to riskier (and often unviable) business models which have been blowing up all over the world. At the same time, instead of receiving their return in the form of dividends, shareholders prefer their return in the form of captial appreciation.
Readers are requested to point out any flaws in my argument as well as to provide their comments.
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8 Responses to “Debt vs. Equity – A Tax Bias?”
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You are probably right. Actually people investing in equities do not change their expectations of returns even though the company starts taking more debt and hence the investors are taking more risk.
According to risk-reward ratio, with higher risk higher return should be expected but probably investors do not take that into account. With more debt companies are easily able to fulfill investor expectations and get credit and bonuses.
When an event like recession happens then everyone wakes up!
differential tax treatment is one way to look at this. however, if i am correct, this differential tax treatment is on purpose. i think its to stimulate growth, with the expectation that businesses and management are ethical enough to manage it diligently. Unfortunately, ethical practices have gone for a toss, in greed for short term bonuses and career growth. the top guy is not going to remain stuck with it to bear the consequences.
I think there are a number of factors that go into choosing between debt and equity. Taxation is one.
Overall cost of debt is a key factor. When equity markets are booming, return expectations are high, cost of equity is high. Cost of debt is generally low (as low interest rate regimes fuel stock market booms). So, most companies prefer debt. Also, for the promoters, the shares they own have a high value and therefore they can raise funds using shares as collateral to infuse into the company. However, dilution on raising equity is lower due to higher valuations.
In bear markets, the valuation of companies are low and promoters (at least in India) are not keen to dilute at these valuations. Also, reduced share prices might cause margin calls on those who have pledged shares leading to a further fall in prices. Therefore, there are limits to raising debt (due to increased debt-equity ratios) and a reluctance to raise equity unless absolutely necessary.
@ Abhishek – The factors you have mentioned above are all valid. However, these are important from a short to medium term prospect. My argument concerns the long run (measured in decades rather than years). Fifty or a hundred years ago, the kind of leverage we are talking about today did not exist, not even in the case of financial institutions.
I would limit my argument for Indian scenario:
First of all Dividends are NOT double taxed. Dividend Income is currently Tax free at the hands of investors.Dividend Distribution Tax is currently 10% for the Company. Second, there is a TDS (>20%) on the interest payments that needs to be collected by the Company, basically interest income (for the lender) is taxed at highest tax bracket.
So, to my mind there is a higher tax incidence somewhere in the system for debt (if not for the borrower it is taxed for the lender).I believe laws are similar in other countries as well.
Interest payments ha to be a tax deducible expense as it indeed a genuine business expense. Defaulting on interest payments can have catastrophic effects on the Borrower’s business.
As a company changes its capital structure more in favor of debt, its Beta continuously increases. Thereby implying heightened risk for equity investors. Also, preferential tax treatment is not the only reason companies prefer debt. Cost of debt is generally lower that Cost of Equity.
Therefore, I strongly disagree that preferential tax treatment of Debt has led to moral hazard. Sub-optimal pricing of risk may be closer to the reason for moral hazard.
I want to put up my hands here and admit to a cardinal mistake – I did not proof read the article properly. As pointed out by my good friend Prithweesh,
‘Company earnings when they flow to investors in the form of Dividends are double taxed, but not in the same way as you suggested: It is taxed at first, in the hands of the company as company’s profits.Second, at the stage where company pays out to investors in the form of DDT.’
Also, as always I seem to have stirred up a hornet’s nest without actually knowing too much about the subject at hand. I guess the best way to settle the argument would be run the numbers, something I should’ve done.
I have very little knowledge about the subject but I think differential tax treatment is somewhat justified as debt financing can leave businesses vulnerable to economic downturns or interest rate hikes. Carrying too much debt is a problem because it increases the perceived risk associated with businesses, making them unattractive to investors and thus reducing their ability to raise additional capital in the future. so, tax deduction given on the interest paid on loans can be a way to make business secure. I think instead of relaying on any of them businesses use both debt and equity financing in a commercially acceptable ratio.
I think it is also essential to differentiate between business risk and financial risk. A firm with a high business risk (hence uncertain cash flow eg. start-up) would prefer not to have financial risk as well, so they go for equity financing (Venture capital). A firm with lower business risk (mature industries where cash flow are stable atleast under normal conditions), prefer to take on financial risk by leveraging. The businesses have to take some risk at every point else there is no way they can generate shareholder value. Tax bias may just be one factor.