1 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

2  Corporate debt bias  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 Outline

Two distinct issues  Bias in corporate financial structures  Multinational debt shifting Debt Bias 3

4 Corporate LevelPersonal Level Debt Tax deductible for CIT 1.Exempt 2.Taxable at PIT Equity Not tax deductible for CIT 1.Exempt 2.Taxable at PIT: - dividend tax - capital gains tax Bias in corporate financial structures

Cost of Capital Debt versus Equity 5 PIT Exempt InvestorPIT Taxed Investor (top PIT)

6 Parent (home) Subsidiary (host) Debt Interest taxable at home-country CIT Interest deductible Equity Dividend exempt (most EU countries) Profit taxable at host-country CIT Multinational Debt Shifting

Coefficient of variation in CIT rates 7

How big is effect on corporate financial structures? Debt Bias 8

Multinational Debt Shifting 9 Source: Hebous and Ruf (2015)

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 Empirical literature debt bias / debt shifting

Summary of empirical findings

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 Main findings of literature

Why do we have a bias? Accounting Administrative Legal Economic Debt Bias 13

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’ It’s the accountants’ fault!

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 Administration: why CIT in the first place?

Debt … … yields fixed return … has limited maturity … has prior claim … has no voting right Legal: what distinguishes debt from equity? But … No dichotomy between debt – equity: hybrids blur distinction –demarcation rules vary Intracompany debt – is there any difference between debt holder and equity owner? Equity … … yields variable return … has unlimited maturity … has residual claim … gives voting right

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 Economic: theory of second best

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) Summing up

Should we care? Debt Bias 19

Using trade-off theories ‘Triangles’ might be small – Weichenrieder- Klautke (2008); Sorenson (2014) Externalities can magnify them – rectangles Business cycle – magnify shocks Externalities of excess debt  Financial Sector Arbitrage – administration and compliance Welfare costs of debt bias

Policy Options Treat all returns as we currently treat equity Treat all returns as we currently treat debt Debt Bias 21

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 Comprehensive Business Income Tax

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 Restrictions to mitigate debt shifting

24 Neutrality properties  Consumption tax – neutral to investment  Neutral to debt/equity; depreciation rules Practically feasible  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 ACE –the love baby in public finance

25 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) ACE – Design

How different is it? Should we care more? Policy options Debt Bias in the Financial Sector 26

How different is it? Debt Bias in the Financial Sector 27

28 M. Keen & Ruud de Mooij, 2015, Debt, Taxes and Banks, JMCB (forthcoming) Banks face regulatory capital requirement Hybrids are particularly important for banks Banks enjoy (implicit) insurance Yet Banks generally hold buffers well above regulatory minima: room for tax bias Banks may already exploit hybrids fully Unclear how corporate governance affected How different do we expect banks to be?

29 Response average bank ≈ average non-bank But: Effect is on hybrid debt negligible Response banks with higher buffers bigger Response by largest banks is smaller (Fig) MNC banks shift debt to low-tax affiliates Should we care (more) about all this? Findings from (small) recent literature

30 Empirical findings – banks of different size Source: Jost H. Heckemeyer and Ruud A. de Mooij (2014)

31 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 non- linear – see Fig) 3. Impact of crisis on GDP / Public debt Should we care more?

Social cost of debt bias in financial sector 32

33 … on taxation and bank behavior 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? Hybrids – effects on risk? Interaction regulation – taxation Cross-border spillovers of taxation But a lots of unknowns still …

Policy Options ? Bank levies – EU experiences Thin-cap / regulatory cap ACE for banks – e.g. UK debate Radical reform: CBIT; R+F base Debt Bias 34