A Third Strike Against US Businesses
By responding hastily and irrationally to the recent upsurge in corporate indebtedness, congressional tax-writing committees might well create a major economic distortion in an already-biased tax code Ind exacerbate the very problem they are trying to solve.
The tremendous potential for gains from leveraged bbuy-outs (LBOs) has made them a recent media fad. Prompted largely by the public hysteria at the Nov. 30 culmination of the largest takeover battle to date for RJR-Nabisco, Capitol Hill politicos went into a virtual panic.
An LBO is the takeover of a company using the company's assets as collateral to borrow enough funds to purchase all the outstanding stock at a premium, effectively leading to the replacement of equity shares with debt. such buy-outs, we are told, cannot be good for the economy since they promote our "hot check" spending proclivities. House Ways and Means Chairman Dan Rostenkowski and Senate Finance Chairman Lloyd Bentsen, among others, feel that the rise of corporate debt must be staved off before it becomes unmanageable.
This recent trend toward LBOs reflects the inherent bias toward debt-financing in the US tax code. Corporations are permitted to deduct interest payments on debt from their taxable income. Equity finance, or capital generated by selling shares of stock, is not treated likewise. On the contrary, the current corporate income-tax structure taxes corporate income twice — once as corporate profits and once through dividend payments to equity shareholders.
It is thus undeniable that our tax system is biased toward corporate debt-financing that encourages LBOs. The congressional folly does not lie in its identification of the problem, but rather in its attempt to solve it.
What many in Congress are proposing is that the corporate tax deduction for interest payments on debt be done away with. If that happens, we will be left with the existing double tax on corporate income and a newly imposed cost for interest paid on debt — a triple whammy against American businesses.
The results would be havoc. First, corporate expansion would be discouraged. Currently, equity-financed expansion has a higher cost than debt-financed expansion. Removing the subsidy to debt would merely succeed in ensuring high costs on all such expansion. In consequence, the economy's employment of capital will be increasingly driven by a desire to minimize tax liabilities rather than maximize efficiency. One of the primary reasons for discouraging LBOs is precisely to avoid such tax-driven decisions. Removing the deductibility of interest paid on debt would only force entrepreneurs to run faster from essentially higher taxes. Finally, and perhaps most importantly, disallowing the deduction for interest would make US buyouts and mergers extremely attractive to foreigners. Germany, Britain, France, and Canada currently provide some form of relief from the double-edged sword of corporate taxation by allowing equity deductions. Most foreign nations concurrently allow the deductibility of interest.
Thus, foreigners would be effectively subsidized by US tax laws for their role in American takeovers and acquisitions. Corporate indebtedness in the United States might fall, but that would in no way squelch "merger mania." It would simply magnify the role of foreigners in the buy-out game.
As an alternative, Congress should strive to eliminate the tax bias against equity by removing the double tax on corporate income, making equity financing of expansion just as attractive as debt-financing. The, trend toward LBOs would likely slow, though expansion and increased economic efficiency could still be pursued vigorously. Furthermore, a recession, when and if it comes, could be more easily managed by the corporate sector through increased reliance on equity investment, rather than cash-flow sensitive debt instruments. As an added perk, the longtime nemesis of corporate double taxation in the tax code would be eliminated.
Unfortunately, we have learned through the years that what Congress should do has no bearing on what it will do. Perhaps a more practical, though less desirable alternative to simply doing away with the double tax on corporate income, would be to trade off a reduction of taxes on equity payments with a corresponding increase in tax revenues from other sources. These other sources might include allowing less of a deduction for interest on debt (thereby equalizing the cost of equity and debt borrowing), or simply raising corporate income-tax rates. In both cases, the bias toward debt-financing would be considerably diminished.
We can be certain, though, that removing the deductibility of interest payments from the tax code would create far more problems that it would solve. By encouraging people to run faster from the sword of taxation, our economy would only slip further into the mire of investment motivated not by economic fundamentals, but rather by a non-market desire to beat the tax system. And merger mania would likely continue, but increasingly at the hands of foreigners.