The FT has got on the right track again in an article today that says:
The depth of the recent financial crisis was largely due to excessively high leverage, or debt-to-equity ratios. Both banks and corporates were heavily indebted at the onset of the financial crisis as low interest rates promoted cheap debt financing.
But there is also a structural bias towards debt financing that encourages companies to take on debt rather than equity. While the cost of debt (interest) is deductible from corporate tax, the cost of equity (dividends) is not. In the wake of the financial crisis, this needs to be addressed — and with urgency.
This is a complex area for reform because of the interaction with personal taxation, but that does not mean it need not be addressed.
Now is the time to do so.
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The cost of equity goes further than purely tax deductibility. Raising equity is expensive and sometimes impossible, it involves diluting ownership, makes it easier for businesses to be taken over etc etc. The advantages of leverage are that the costs are fixed and thus shrinking if you borrow to invest.
The recommendation in the article is that debt interest and depreciation of assets should no longer be tax deductible to encourage an equity buffer. That may be sustainable for large businesses already listed – but would create a huge barrier to small start-up businesses that would struggle to attract sufficient equity ownership to expand. To be frank – this proposal would be disasterous for the economy.
I agree there is a problem, the answer lays in responsible lending to ensure that the equity holders are shouldering a fair share of the risk. The banks are doing this by asking for additional personal collateral to be put up as security on debt.
I believe there is a proposal to make the cost of equity tax deductible which is currently under consideration. Iam not sure whether the cost will be an imputed or real cost. If real then equity holders will become entitled to a guaranteed return. It is unclear what the consequences might be. Won’t such a proposal increase gearing?
@James
The answer is in different rules for small and large business
To argue they are the same as the current system assumes is absurd
I have argued this recently at the Office for Tax Simplificiation
@Stephen
That comes from the Mirrlees report and like the other hair brained elements of that emanating from the Oxford Centre for the Non-Taxation of Business is not to be trusted – being riddled with all the faults of its hidebound neoliberal thinking that is as far removed from reality as I am from Jupiter
This is an elegant proposal for structural reform, although it would undoubtedly be much more helpful to most businesses and for job creation to reduce NI contributions rather than “allowing a lower tax deductibility both on interest and dividends at the same rate” in order to “keep the net tax payment of corporates to government at the same level”. I was also very interested in the statement that “by removing interest deductibility across all countries, there would be no scope for tax arbitrage.” Now, how do we discover how big the tax shield is in the UK for fincos (as opposed to PNFCs for which figures are already available)?