Does Jeb Bush Really Want to Upend the Bond Market?
Buried deep in Jeb Bush's tax plan is a 15-word bombshell that has gone largely unnoticed in the days since it was unveiled. The Republican presidential candidate proposes to eliminate the deduction that corporations take for interest expenses, thus closing off a tax break that saves U.S. companies billions of dollars a year.
This is huge. And while it has merit, it's also so disruptive to the way companies finance themselves that it could destroy value and, along the way, create new and unpredictable economic distortions. It could even result in less, not more, corporate investment -- the opposite of what Bush thinks he's achieving.
Bush's plan will upset businesses that are highly leveraged, but he's right that the tax code should be more neutral. Currently, companies finance themselves by issuing stock or by borrowing, which can be via a bank loan or a bond issuance.
The tax code lets companies deduct the interest paid on debt. But equity is treated differently: Profits from equity investments are subject to the statutory 35 percent tax rate. And dividends paid to shareholders out of corporate earnings are taxed at 23.8 percent.
In a nutshell, this tax-code preference for debt over equity explains why companies prefer to issue bonds over selling shares.
Bush's tax blueprint merely says he will "remove the deduction for borrowing costs. That deduction encourages business models dependent on heavy debt." This could be a political expediency, one that allows his numbers to add up and avoid voter fallout.
Why? Bush would also lower corporate taxes to 20 percent and let companies immediately deduct the cost of capital investments, such as technology and new office buildings, instead of having to spread those costs over many years. If he didn't end the deduction for interest expense at the same time, he might be giving profitable companies deeply negative tax rates, meaning the IRS would be writing them fat checks.
But let's accept that he really does want to level the playing field between debt and equity. He joins many economists, including those at the International Monetary Fund, who decry the tax code's bias toward debt. They believe it has led to excessive borrowing, sometimes leaving companies no choice but to declare bankruptcy when they can't repay creditors in lean times. High borrowing rates led to the 2008 financial crisis and elongated the recovery.
Bush doesn't mention this, but the debt-over-equity bias has also allowed executive compensation to swell. Some of the recent corporate borrowing binge is taking place so that companies can buy back their stock, which pushes up share prices and also happens to boost executives' stock-based pay.
Bush also doesn't mention that deductibility of interest subsidizes private-equity firms. Many of their buyouts are possible only through heavy borrowing, which uses the acquired company's assets as collateral, leaving financially strapped companies struggling to survive.
The debt bias hurts startups and small businesses, which have higher financing costs because they can't borrow the way mature companies can. Small companies lack the hard assets that banks require as collateral for loans, or the credit ratings the bond market demands for a debt issue. That leaves them little choice but to use equity, often by giving up large ownership shares, just to raise enough money to hire employees and rent office space.
Possibly the most harmful aspect of the debt bias is that it encourages financial institutions to borrow to the hilt. Highly leveraged banks were unable to absorb losses once the value of their assets declined in the 2008 crash, forcing the U.S. to bail them out. Bush's plan, however, would allow financial institutions to continue to deduct their interest payments. In carving out an exception for them, he and his advisers, including economists Martin Feldstein and Glenn Hubbard, may not have wanted to take on the likes of JPMorgan Chase, Bank of America and the rest, which borrow heavily.
There are many reasons to end the bias against equity, but it could be destabilizing to suddenly end interest deductions. The U.S. corporate bond market, which is huge, could be decimated. Companies sold on average $1.4 trillion in debt a year for the last three years. This year, companies could top that as they rush to issue bonds before the U.S. Federal Reserve raises interest rates. By contrast, companies issued only $311 billion in equity (including initial public offerings and follow-on share issuances) in 2014 and $204 billion so far in 2015.
Without interest-payment deductions, bank loans would suddenly be unpopular, possibly harming the financial health of some U.S. banks. Nondeductible interest could, as one commentator wrote, eradicate the leasing business, which is a form of lending, "and make property development almost impossible."
Most other countries' tax systems also favor debt over equity, so ending it in the U.S. could lead to more companies moving offshore to keep the tax break. Or it could leave U.S. companies less competitive against European and Asian rivals, who would have lower financing costs. And that could dampen corporate investment.
Bush's proposal is too vague to evaluate the biggest unknown of all: the effect on investors in existing corporate debt. Would returns be higher or lower? If companies issued fewer bonds, would retirement funds be able to find enough low-risk assets, such as highly rated corporate bonds, in which to invest?
There are too many questions to truly evaluate Bush's idea. As we know from painful experience, changes in U.S. tax policy need to be meticulous and precise. So it's back to the drawing board on this one.
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