To Owe or Be Owned—Depends on How You Tax It
IMF Blog, May 13, 2011
Source details
- Canonical URL
- To Owe or Be Owned—Depends on How You Tax It
Other formats
Bibliographic details
- Authors: Ruud de Mooij
- Published: May 13, 2011
Executive summary
- Author: Ruud de Mooij; Date: May 13, 2011.
- Core proposition: Corporate tax systems that allow interest deductibility but do not allow comparable deductions for returns on equity create a significant bias toward debt finance over equity.
- Policy objective: End the debt bias in corporate income tax by either restricting interest deductibility or introducing an allowance for corporate equity.
Problem: nature and scope of the debt bias
- Key mechanism: Interest paid on borrowing can be deducted from the corporate tax bill, while returns paid on equity—dividends and capital gains—cannot.
- Consequence: The tax code “pays companies to invest using leverage.”
- Geographic scope: The U.S. faces this bias; in most of Europe, Asia and elsewhere the tax advantages of debt finance are even bigger.
- Behavioral responses worsening distortions:
- Firms respond more aggressively to the tax bias of debt.
- Financial innovation has blurred the distinction between debt and equity, creating opportunities for tax avoidance.
- Multinational firms reallocate debt and equity across countries to exploit favorable tax environments, eroding corporate tax bases.
Macro-financial consequences
- Excessive leverage is more costly than previously recognized.
- The global financial crisis demonstrated that excessive leverage ratios in financial institutions can create massive spillover effects to the rest of the economy and beyond national borders.
- Financial distortions have grown larger in recent years, increasing vulnerability of public finances, especially in advanced economies under strain.
Policy alternatives analyzed
- Two broad reform options presented:
- Restrict or eliminate the deductibility of interest for corporate profits.
- Effect: broaden the corporate tax base and free revenue for reductions in the statutory rate.
- Practical challenges: restrictions (as opposed to elimination) lead to complex rules that firms can circumvent; make investment more expensive and can hurt economic growth.
- Introduce an allowance for corporate equity (a deduction for normal equity returns).
- Mechanism: allow a deduction for the value of returns on equity based on, for example, the long-term government bond rate; retain traditional interest deduction while leveling the debt-equity playing field.
- Intended effects: remove bias against equity investments, promote investment, economic growth and job creation.
Evidence and expected impact
- Reform estimate: the allowance-for-equity reform “can raise GDP by some 3 percent.”
- Country experience: Belgium, Brazil and Latvia have moved toward such systems with some success during the last decade.
Implementation considerations and trade-offs
- Complexity and avoidance:
- Partial restrictions on interest deductibility can become complex and susceptible to avoidance.
- Short-term revenue effects:
- Some governments may be reluctant to introduce an allowance that will narrow the corporate tax base in the short run.
- A design option to limit revenue loss: grant the allowance only to new investment.
- Longer-term benefits:
- Improved tax design can make economies less vulnerable to future financial crises, preventing large costs in terms of lost revenue.
- Eliminating debt-equity distortions could ultimately broaden corporate tax bases.
Policy recommendation
- The allowance for corporate equity deserves serious consideration as a means to end the debt bias in corporate income tax and to align tax incentives with financial stability and growth objectives.
To Owe or Be Owned—Depends on How You Tax It, Ruud de Mooij, May 13, 2011
Content in this bundle
- Staff Discussion Note
- wp1195 — Summary of Studies Using Single Country Data