Most of the debate about corporate tax reform has centered on what’s being called the border adjustment. Instead of taxing profits based on where a company is owned, the new system being proposed by congressional Republicans would tax them based on where the sales were made, effectively giving a subsidy to exports relative to imports.
But as important as the border adjustment is, it might not be the most significant change in the tax reform plan. The House plan would also fundamentally change the way that U.S. corporations finance themselves, wreaking huge changes in U.S. financial markets in the process.
Currently, when companies borrow money, a large portion of the interest they pay on those loans is tax-deductible. The House plan would eliminate that deduction. Like the border adjustment, this change was proposed by Berkeley economist Alan Auerbach in a famous 2010 paper, “A Modern Corporate Tax.”
How would companies finance themselves if interest payments weren’t tax deductible? They would take on less debt and issue more stock. That would require some big adjustments, but in the long term it would probably be a good thing for the stability of the economy.
A historical study by economists Oscar Jorda, Moritz Schularick and Alan Taylor found that when debt levels in an economy are high, asset-price crashes cause more economic harm. That fits with the theories of Yale economist John Geanakoplos, who showed how leverage can amplify economic shocks and cause big recessions.
Corporate debt can also be involved in economic disasters. In South Korea in the 1990s, large conglomerates known as chaebols borrowed a lot of money, resulting in huge financial problems after the Asian financial crisis of 1997. As Jorda, Schularick and Taylor would have predicted, the Korean economy experienced a sharp recession and a long growth slowdown. Today, China’s high corporate debt may put it in danger of a similar slowdown.
In the U.S., the debt of nonfinancial companies is not a big problem. These companies have borrowed only about a third of their stock-market value, and this ratio has come down in recent years:
By contrast, U.S. banks are really big borrowers. U.S. commercial banks tend to have ratios of debt to book value above 2 to 1, and investment banks above 3 to 1. That’s in contrast to a ratio of about 0.56 to 1 for the whole economy. So banks tend to finance themselves with debt a lot more than other kinds of companies.
In addition to the standard risk posed by debt, bank leverage creates systemic risk for the economy, because of moral hazard. If big banks fail, the government will have to bail them out, and this gives them an incentive to take more risk in the first place. The government can try to use regulation to minimize that risk, as with the recent Dodd-Frank financial reform or the safeguards put in place after the Great Depression. But this regulation comes at an economic cost, because it can gum up the workings of the finance industry.
Instead of trying to micromanage big banks, many economists have suggested that the government require banks to borrow less. Stanford’s Anat Admati, for example, has been a tireless crusader for higher bank capital requirements (which force banks to use more equity and less debt). She has been joined by my own doctoral adviser, Miles Kimball, as well as many others. John Cochrane of the Hoover Institute has even gone so far as to suggest forbidding banks from borrowing at all.
Cochrane’s proposal is almost certainly too excessive, but the general idea — making the financial system safer by incentivizing equity over debt finance — is a sound one. Capital requirements are part of the solution — Dodd-Frank and the Basel III international regulatory framework have raised these somewhat, though more could be done. But changing the corporate tax system to remove the incentive for leverage, as House Republicans are now proposing, would also push in this direction.
That’s the long-term benefit. But in the short term, the House’s tax plan would hurt the business models of companies like banks that rely heavily on debt. The economy will need time to adjust to this big change, as managers learn how to change their business models, and as resources are shifted away from companies that rely on cheap debt. In order to protect workers from the inevitable disruptions, the tax change should be phased in over a period of five to 10 years.
Eventually, though, a less debt-reliant economy would be a good thing. In all the hubbub over the border adjustment, this important piece shouldn’t be forgotten.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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