The current crisis highlights the need for corporate resilience in the face of unpredictable threats to supply and demand. Reforming the tax regime to favour equity financing over debt leverage would help achieve this.
Even after the financial crisis of 2008, many economists and policymakers remained reluctant to acknowledge that decisions are frequently made in conditions of radical uncertainty. Such reluctance may be lower after the COVID-19 crisis. Policymakers, entrepreneurs, and consumers are becoming accustomed to deciding how to act when they cannot know what the future holds. In this context, there may be a greater premium placed on narratives and policy ideas that promise greater resilience in the future.
After the financial crisis, policymakers were determined to improve the resilience of the banking system – in particular, by raising capital buffers and decreasing bank leverage. Banks could no longer prioritise short-term return on equity. After the COVID-19 crisis, it is a fair bet that health systems will similarly react by moving away from a static efficiency model that prioritises the most efficient use of scarce resources in normal times to one that prizes spare capacity in the form of normally under-used ICU beds and increased stocks of emergency protection equipment.
I would argue that there needs to be an equal determination to re-imagine the world of non-bank corporate financing to one where companies are incentivised by changes in the tax regime (and perhaps also in monetary policy and corporate governance) to hold more equity capital, more cash for a rainy day, and less debt leverage. This would involve sacrificing some short-term return on equity in good times in favour of companies becoming more resilient to shocks.
During the 25 years since I was an equity fund manager, there has been a sustained assault on older ideas of corporate strength as depending on a large capital base, strong cash flow, and diversified income streams designed to help companies survive (and hold onto their workforce) during downturns. In the world of financialised capital, the ideal company has become one with high levels of gearing and as little equity and unused cash reserves as possible. Debt has increasingly replaced equity financing; and indeed, in many cases, debt has been used for share buy-backs to reduce the denominator of return-on-equity calculations. These trends have been exacerbated by remuneration systems for executives based on share options that incentivise prioritising artificial financially-engineered rises in return on equity.
The impact of these trends has been significant. Many argue that the move from equity to debt financing has contributed strongly both to income and wealth inequality and to low productivity, by allowing managers of firms – or the private ‘equity’ owners who have loaded their target companies with debt – to extract value without adding to the long-term productive capacity of firms. But, wherever you stand on these general corporate governance and moral issues, there is a strong argument in favour of returning to an older model of equity financing for purely corporate and system resilience reasons.
Companies financed with equity held by long-term investors (pension funds, insurance companies etc) rather than with debt are more resilient to downturns: if profits suddenly fall they can reduce or suspend dividend payments without defaulting. The value of shares may fall sharply but this need hurt only those shareholders obliged by their own high gearing levels to sell the shares at the moment of crisis. As a result, the downturn is less likely to become a balance-sheet problem leading to mass lay-offs or the sudden bankruptcy of otherwise viable companies. The system is also more modular (a key feature of resilience): if an equity-financed company does go under and its shares become worthless, the write-down of equity is less likely than a default on bank debt or corporate bonds to damage liquidity in the banking sector and lead to financial contagion.
Equity financing is also more resilient because equity owners are motivated by positive imaginaries of post-crisis opportunities as well as calculations of downside risk during the crisis. The imagined upsides are not bounded as they are for holders of debt by the absence of default risk. Equity investment is also a more stable way of recycling large macroeconomic imbalances between countries than short-term debt instruments that are particularly subject to capital flight.
So how can policymakers shift the balance back towards equity financing? They can do this principally by a carefully managed change to the corporate tax regime. At present dividends are paid out of taxed profit but interest payments are deducted from taxable income. In future, the tax treatment of interest coupons and dividends should become neutral by taxing profits before deduction of interest. Exceptions should be made for the financing of working capital – since high stock levels also help corporate resilience.
In return for this large increase in tax payable by highly leveraged companies, the overall corporate tax rate could be reduced and tax allowances reintroduced for (debt- or equity-financed) investment in productive assets and capital machinery. In this way, the current tax incentives for high debt leverage would be replaced by tax incentives for real investment.
This simple but far-reaching reform would reduce the credit-intensity of the economy and thereby improve its resilience. It would also over time free central banks from their current bind where they cannot wean an over-indebted corporate sector off the opiates of distortionary low-interest-rate and quantitative-easing policies without risking mass defaults.
The suggested reforms to the tax treatment of debt could complement wider corporate governance reforms, such as those proposed by Goodhart and Lastra. Moreover, when governments need to intervene to protect the economy in the face of a shock, an equity-financed system would enable them to do this by taking equity stakes in troubled but long-term viable companies rather than extending them yet more debt finance. As Blyth and Lonergan argue, these government equity stakes could then be handed over to newly-created sovereign wealth funds so that society can share in the upside potential of post-crisis economies.
Richard Bronk, Visiting Senior Fellow, European Institute, London School of Economics