Debt, equity and corporate welfare
Recently we blogged on the scandal of tax relief on corporate debt payments -- both the IMF waking up to the problem, and Richard Murphy's astute observations on this issue, in his blog "Rebuilding the bias to equity."
Now we have Prem Sikka writing on the same issue. This is such an important article that we hope we will be forgiven for reproducing nearly all of it. The effects of this system are momentous. Read it all to see why this matters so much.
"The further degradation of education, transport, healthcare or pensions will not help hard-pushed citizens, or businesses that rely on public spend. As always, there are alternatives. Let us cut the welfare programme enjoyed by corporations – for example, the tax relief on borrowings. This would also help to address excessive leverage, one of the causes of the banking crisis as well.
The current financial crisis shows that banks have been addicted to debt. They had very high-leverage ratios, ie borrowings in the form of debt were very high compared to the long-term funds provided by shareholders. The significance of high leverage was demonstrated by the demise of Lehman Brothers, which had a leverage ratio of 30 to 1. An expert told a US House of Representatives committee that "with this leverage, a mere 3.3% drop in the value of assets wipes out the entire value of equity and makes the company insolvent". Elsewhere major banks had leverage ratios in the range of 11:1 to 83:1 that inevitably contributed to their problems.
Companies borrow for a variety of reasons. One reason is that it enables them to give higher returns to shareholders, something that also boosts executive remuneration, which is often linked to profits. A key point is that the payment of interest qualifies for tax relief. Companies can offset the interest cost against their taxable profits. With corporation tax at 28% this reduces the real cost of borrowing, ie with tax relief the £100 cost of borrowing effectively becomes £72. Not surprisingly, a debt-fuelled shadow economy consisting of hedge funds and private economy has sprung up where a small change in interest rates can magnify profits many times over.
The perils of high leverage are recognised by the government, by the Conservative party and the Financial Services Authority. Eliminating the tax relief on corporate debt is the obvious solution to reducing the corporate addiction to debt, but no one advocates it.
The neocons have never tired of telling us that tax reliefs distort markets and should be abolished. Based on this logic, in 1988 the Conservative government began to dismantle the tax relief available to individuals on mortgage interest payments, and it was finally abolished in 2000 by the Labour administration. In general, an individual cannot receive tax relief on interest payments whether the debt is for buying a house, car, fridge, cooker or anything else. In contrast, the tax concessions to corporations have been maintained regardless of whether the debt is for buying productive assets, or speculating in markets, paying exorbitant dividends, setting up operations in tax havens, or even champagne parties for friends. Though the exact figures are hard to calculate this gives companies enormous financial advantage and encourages them to finance their activities through debt rather than long-term equity.
Elimination of the tax relief on corporate interest payment would not prevent companies from using debt finance. Instead, it would add an element of neutrality into their choice of capital structure since payments of dividends to providers of equity do not qualify for tax relief. The ending of the taxpayer subsidy would also force companies to maintain more moderate levels of leverage. The measure would increase tax revenues that can be used to fund pensions, healthcare, education, public transport, reduce public borrowings and even tax cuts for normal people, and provide a much needed stimulus to the economy.
Corporate barons used to subsidies and welfare programmes will not like parity with the tax regime faced by normal people. They would oppose the withdrawal of their tax perks by citing dire consequences. Some weeks ago, George Osborne indicated that he might consider scrapping tax relief on debt interest. It drew protests and the Conservatives "swiftly abandoned" the idea. Instead, cuts in public expenditure and tax rises for normal people have been mooted as the official policy even though this will increase unemployment and reduce the spending power of normal people.
Cutting and slashing public investment and social rights should not be the first option. There should be a public debate about ending corporate welfare programmes. Not only the tax relief on corporate interest payments, but also the subsidies enjoyed by agribusiness, railway, armament, energy and other businesses."
Now we have Prem Sikka writing on the same issue. This is such an important article that we hope we will be forgiven for reproducing nearly all of it. The effects of this system are momentous. Read it all to see why this matters so much.
"The further degradation of education, transport, healthcare or pensions will not help hard-pushed citizens, or businesses that rely on public spend. As always, there are alternatives. Let us cut the welfare programme enjoyed by corporations – for example, the tax relief on borrowings. This would also help to address excessive leverage, one of the causes of the banking crisis as well.
The current financial crisis shows that banks have been addicted to debt. They had very high-leverage ratios, ie borrowings in the form of debt were very high compared to the long-term funds provided by shareholders. The significance of high leverage was demonstrated by the demise of Lehman Brothers, which had a leverage ratio of 30 to 1. An expert told a US House of Representatives committee that "with this leverage, a mere 3.3% drop in the value of assets wipes out the entire value of equity and makes the company insolvent". Elsewhere major banks had leverage ratios in the range of 11:1 to 83:1 that inevitably contributed to their problems.
Companies borrow for a variety of reasons. One reason is that it enables them to give higher returns to shareholders, something that also boosts executive remuneration, which is often linked to profits. A key point is that the payment of interest qualifies for tax relief. Companies can offset the interest cost against their taxable profits. With corporation tax at 28% this reduces the real cost of borrowing, ie with tax relief the £100 cost of borrowing effectively becomes £72. Not surprisingly, a debt-fuelled shadow economy consisting of hedge funds and private economy has sprung up where a small change in interest rates can magnify profits many times over.
The perils of high leverage are recognised by the government, by the Conservative party and the Financial Services Authority. Eliminating the tax relief on corporate debt is the obvious solution to reducing the corporate addiction to debt, but no one advocates it.
The neocons have never tired of telling us that tax reliefs distort markets and should be abolished. Based on this logic, in 1988 the Conservative government began to dismantle the tax relief available to individuals on mortgage interest payments, and it was finally abolished in 2000 by the Labour administration. In general, an individual cannot receive tax relief on interest payments whether the debt is for buying a house, car, fridge, cooker or anything else. In contrast, the tax concessions to corporations have been maintained regardless of whether the debt is for buying productive assets, or speculating in markets, paying exorbitant dividends, setting up operations in tax havens, or even champagne parties for friends. Though the exact figures are hard to calculate this gives companies enormous financial advantage and encourages them to finance their activities through debt rather than long-term equity.
Elimination of the tax relief on corporate interest payment would not prevent companies from using debt finance. Instead, it would add an element of neutrality into their choice of capital structure since payments of dividends to providers of equity do not qualify for tax relief. The ending of the taxpayer subsidy would also force companies to maintain more moderate levels of leverage. The measure would increase tax revenues that can be used to fund pensions, healthcare, education, public transport, reduce public borrowings and even tax cuts for normal people, and provide a much needed stimulus to the economy.
Corporate barons used to subsidies and welfare programmes will not like parity with the tax regime faced by normal people. They would oppose the withdrawal of their tax perks by citing dire consequences. Some weeks ago, George Osborne indicated that he might consider scrapping tax relief on debt interest. It drew protests and the Conservatives "swiftly abandoned" the idea. Instead, cuts in public expenditure and tax rises for normal people have been mooted as the official policy even though this will increase unemployment and reduce the spending power of normal people.
Cutting and slashing public investment and social rights should not be the first option. There should be a public debate about ending corporate welfare programmes. Not only the tax relief on corporate interest payments, but also the subsidies enjoyed by agribusiness, railway, armament, energy and other businesses."
posted by TJN at 1:51 am
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