Debt Bias
Conceptual Analysis of the Issue
EC – IMF Conference on Corporate Debt Bias
23 – 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
1
Outline
 Corporate debt bias
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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
2
Debt Bias
Two distinct issues

Bias in corporate financial structures
 Multinational debt shifting
3
Bias in corporate financial structures
Debt
Equity
Corporate Level
Personal Level
Tax deductible
for CIT
1. Exempt
2. Taxable at PIT
Not tax deductible
for CIT
1. Exempt
2. Taxable at PIT:
- dividend tax
- capital gains tax
4
Cost of Capital Debt versus Equity
PIT Exempt Investor
PIT Taxed Investor (top PIT)
16
16
12
12
8
8
4
4
0
0
US
Japan
Equity
Debt
Europe (27)
US
Japan
(New) Equity
Europe (27)
Debt
5
Multinational Debt Shifting
Debt
Equity
Parent
(home)
Subsidiary
(host)
Interest taxable at
home-country CIT
Interest deductible
Dividend exempt
(most EU countries)
Profit taxable at
host-country CIT
6
Coefficient of variation in CIT rates
10%
World
Europe
5%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
7
Debt Bias
How big is effect on
corporate financial structures?
8
Multinational Debt Shifting
Source: Hebous and Ruf (2015)
9
Empirical literature debt bias / debt shifting

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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
Summary of empirical findings
70
60
National variation
50
40
Cross-country
variation
30
20
10
0
<0
< 0; ¼>
< ¼;½>
< ½; ¾>
<¾; 1>
<1;1¼> <1¼;1½>
> 1½
Main findings of literature

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
Debt Bias
Why do we have a bias?
Accounting
Administrative
 Legal
 Economic
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It’s the accountants’ fault!

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’
Administration: why CIT in the first place?

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
Legal: what distinguishes debt from equity?
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Debt …
… yields fixed return
… has limited maturity
… has prior claim
… has no voting right
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Equity …
… yields variable return
… has unlimited maturity
… has residual claim
… gives voting right
But …
No dichotomy between debt – equity: hybrids blur
distinction –demarcation rules vary
Intracompany debt – is there any difference
between debt holder and equity owner?
Economic: theory of second best
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

Summing up

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)

Debt Bias
Should we care?
19
Welfare costs of debt bias

Using trade-off theories
 ‘Triangles’ might be small – WeichenriederKlautke (2008); Sorenson (2014)

Externalities can magnify them – rectangles
 Business cycle – magnify shocks
 Externalities of excess debt  Financial Sector
 Arbitrage – administration and compliance
Debt Bias
Policy Options
Treat all returns as we currently treat equity
 Treat all returns as we currently treat debt

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Comprehensive Business Income Tax

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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
Restrictions to mitigate debt shifting

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
ACE –the love baby in public finance

Neutrality properties
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Practically feasible
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Consumption tax – neutral to investment
Neutral to debt/equity; depreciation rules
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
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ACE – Design
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
x
Rate of the ACE
(risk-free rate of return)
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Debt Bias in the Financial Sector

How different is it?

Should we care more?

Policy options
26
Debt Bias in the Financial Sector
How different is it?
27
How different do we expect banks to be?
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
M. Keen & Ruud de Mooij, 2015, Debt, Taxes and
Banks, JMCB (forthcoming)

Banks face regulatory capital requirement
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Hybrids are particularly important for banks
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Banks enjoy (implicit) insurance
Yet
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Banks generally hold buffers well above
regulatory minima: room for tax bias
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Banks may already exploit hybrids fully
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Unclear how corporate governance affected
28
Findings from (small) recent literature
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Response average bank ≈ average non-bank
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But:
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Effect is on hybrid debt negligible
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Response banks with higher buffers bigger
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Response by largest banks is smaller (Fig)
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MNC banks shift debt to low-tax affiliates
Should we care (more) about all this?
29
Empirical findings – banks of different size
Source: Jost H. Heckemeyer and Ruud A. de Mooij (2014)
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Should we care more?

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 nonlinear – see Fig)
3.
Impact of crisis on GDP / Public debt
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Social cost of debt bias in financial sector
Increase in probability of crisis due to debt
bias
45
Crisis Countries
40
35
Borderline Crisis
30
Others
FRA
DEU
LUX
NLD
25
20
NOR IRL
15
10
5
0
0.86
KOR
ISR SWE
CAN
ITA FIN GRC
POLCHL SVN ESP
DNK
USA MEX EST
NZL
SVK
AUT
HUN
BEL
TURPRT
0.88
0.9
0.92
0.94
0.96
Bank Leverage ratio (liabilities/assets)
0.98
32
But a lots of unknowns still …

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… on taxation and bank behavior
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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?
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Hybrids – effects on risk?
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Interaction regulation – taxation
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Cross-border spillovers of taxation
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Debt Bias
Policy Options ?
Bank levies – EU experiences
 Thin-cap / regulatory cap
ACE for banks – e.g. UK debate
Radical reform: CBIT; R+F base
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34