IMF on debt bias and other distortions

Last year the IMF issued an important, though flawed, report on how tax policies and secrecy jurisdictions boosted leverage in the financial system and contributed to the global financial (and economic) crisis that erupted in 2007. These issues, it reports, have been "little explored." The IMF paper is here and the summary here. We have reviewed this before, in piecemeal fashion, but our last edition of Tax Justice Focus contained a more detailed and comprehensive review of the paper. Given the importance of this issue, we are reproducing our TJF review here, in full.

In June 2009 the IMF Fiscal Affairs Department issued an important paper, Debt Bias and Other Distortions: Crisis-Related Issues in Tax Policy, which looks at how tax distortions have contributed to the build-up of debt in our societies.

This IMF paper has a central premise: that tax distortions and tax havens have played a major role in the build- up of debt and complexity in the financial system, contributing to the latest financial and economic crisis. It supports previous TJN analyses from 2007 onwards pointing out exactly these problems.

Two main issues stand out.

First, when a corporation borrows money then pays interest on the loan, it can generally deduct the interest payments against tax. In addition, if the subsidiary or financing partner records those interest payments in a zero-tax haven, it cuts its tax bill that way. The distortion is that if the corporation, by contrast, funds itself through equity finance, it gets no comparable deduction. The distortion gives corporations powerful incentives to load up with debt, rather than to seek financing through equity markets.

The effect is very large: “These distortions create advantages to the use of debt measurable in hundreds of basis points,” the IMF says. With a corporation tax rate of 20 percent, it estimates that a debt-equity ratio that would be 40 percent under a neutral system, would increase to roughly 45–60 percent. In almost all cases, this makes debt finance cheaper even than the use of retained earnings in most countries.

Leveraged buy-outs are a case in point. Private equity firms and others routinely borrow to buy profitable companies, then deduct the interest costs in the high-tax country, and realise the interest income tax-free, offshore. At a corporation tax rate of 30 percent, the taxpayer gives a 30 cent subsidy to the private equity company for every $1 of interest paid.

This engineering does nothing to promote higher productivity or real value creation – it merely transfers wealth directly from taxpayers to private equity firms, and indirectly transfers wealth by boosting leverage in the financial system, which has led to taxpayer bailouts.

A second problem with the tax distortions, the IMF concludes, is that they encouraged the use of complex financial instruments and arrangements, creating new risks and damage to the real economy. “Financial innovation has been driven primarily by the search for new ways to allocate risk, but also by tax avoidance,” it said. Securitisation creates three main tax issues: first, whether capital gains on assets placed in a Special Purpose Vehicle (SPV) are taxable; second, whether the SPV itself is taxable; third, whether and how payments to holders of SPV assets are taxed.

One focus of financial innovation, the IMF notes, has been to construct hybrid instruments with many features of equity but enough features of debt to attract interest deductibility. This comes at a cost: not only loss of corporate income tax revenue, but also “increased complexity and opacity of financial arrangements” which “may hamper financial supervision.” As TJN has noted, certain jurisdictions – notably Delaware and the Cayman Islands for the U.S., and in Ireland, Luxembourg, Jersey, and the United Kingdom, for Europe – specialise in creating exactly the right legal environment for such engineering. All are major secrecy jurisdictions.

These distortions are especially important with respect to financial services corporations, and go a long way towards explaining the rapid growth in size and riskiness of the financial services industry. As the IMF notes, the tax bias towards debt for financial firms conflicts directly with financial regulation, which tries to lean against debt. And debt is especially important for financial institutions, because they have been so unusually profitable – making the returns on this debt-related tax engineering all the greater.

The paper also notes that the OECD’s recent (feeble) efforts to address problems caused by tax havens entirely ignores these issues, by focusing merely on criminal tax evasion, while ignoring these issues of legal tax avoidance.

The IMF is quite right to identify these major and harmful distortions in international tax. Capitalists are supposed to take risks with their money – and reap the profits or losses that flow from them. Instead, these tax subsidies (and the IMF explicitly agrees that they are subsidies) help capitalists take, and even magnify, their profits – then shift the risks and losses onto others; in the process, capitalism has been thoroughly corrupted. Reform these distortions, and capitalists will do what they do best – take on both the risks, and the rewards.

Having made these extremely useful and important points, however, the IMF then loses its nerve, and veers off in completely the wrong direction.

The answer, it says, is artificially to create a hypothetical return on shareholders’ equity, which it calls Allowance for Corporate Equity (ACE,) and then make that tax- deductible! In other words, leave interest payments tax-deductible – but give these subsidies to equity capitalists too: cut the tax burden on the wealthy. Perhaps by way of an excuse, the authors add that “little is known of the welfare costs of these distortions.” (Later, while discussing the issue of interest deductibility in the mortgage markets, for which these problems are also a major issue, they admit that “deductibility likely favors the better off.”)

The IMF mentions, but fails to endorse, the obvious and much better alternative: stop allowing corporations to cut their tax bills by deducting interest payments. This would level the playing field towards equity finance just as effectively – and help stem the tidal wave of wealth redistribution, from poor to rich. And it would give the tax havens a kick in the teeth, to boot.