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.

High debt-to-equity ratios can cause multiple bankruptcies. Equity acts as a buffer, as it can absorb losses. After its equity is extinguished, a company will go bankrupt. It is therefore important that banks and corporates operate with sufficiently high equity buffers (that is, low leverage ratios). High leverage encourages excessive risk-taking by shareholders at the expense of creditors and governments.

Charles Kindleberger and Hyman Minsky, the classical economists, earlier analysed the key role of leverage in crises. In the boom-bust cycle, cheap credit typically fuels the boom. Leveraged speculation drives up asset prices.

But when the tide turns, the value of assets drops while the (nominal) value of debt remains the same. This can lead to a loss spiral at the height of a crisis as the losses on assets directly reduce equity capital.

In the aftermath of a crisis, companies face the debt overhang problem. Informed financiers refrain from injecting additional equity since the proceeds are primarily going to existing debt holders rather than the new equity holders. Many banks and corporates currently face this debt overhang problem.

Our proposal is to reform corporate tax in order to remove the structural bias towards debt financing. As governments have to tighten fiscal policy anyway, now is a good time to reform corporate tax. It is a historical accident that interest, alongside other costs such as wages and depreciation of fixed assets, is deductible from corporate tax.

In corporate finance, this tax advantage is known as the tax shield. Corporate finance textbooks urge students to maximise this tax shield, up to the point that the cost of distress takes over. That is what we see in practice.

From a stability perspective, we want the opposite: large equity buffers to absorb losses and only modest amounts of debt. A removal of interest deductibility should be done in an international context. A first reason is to keep the playing field level. A second is to reduce the scope for circumventing the tax rules.

Transfer pricing is a favourite hobby of corporate treasurers to exploit loopholes as well as differentials between national tax codes. By removing interest deductibility across all countries, there would be no scope for tax arbitrage.

The proposed tax reform would also reduce regulatory arbitrage. Banks play the game of issuing subordinated debt that in normal times is tax deductible and in crisis times converts to equity.

Why should we allow banks to issue contingent capital (debt that converts to equity) in order to game the system? There is nothing wrong with straight equity financing.

The main objection to removing the interest deductibility is that it would sharply raise the overall tax costs of corporates. This could, at least in principle, be addressed by allowing a lower tax deductibility both on interest and dividends at the same rate that would keep the net tax payment of corporates to government at the same level.

There would be an impact on markets. The long-term effect would be that equity markets expand at the expense of bond markets. Bond yields would be expected to go down due to lower risk (reduced leverage) and less supply of bonds (given equal demand).

Yet tax reform is in the hands of politicians. Maybe the Group of 20 leaders should focus on easy-to-implement structural reforms within their own direct remit rather than fighting about monetary policy and exchange rates.

Dirk Schoenmaker is dean of the Duisenberg School of Finance in Amsterdam. This piece was co-authored by Charles Goodhart, emeritus professor of banking and finance at the London School of Economics

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