Appendix 1. Taxes and the Cost of Corporate Finance
This appendix explains the tax effects on the costs of retention and new equity finance given in Box 2 and discussed in the text.
For retention finance, note first that if the company retains an additional $1 of after-tax income this costs the shareholder $ (1-TD ) as forgone after-tax dividend, where TD denotes the rate of tax on dividends at personal level. This could have been lent out to generate interest income R that would have been taxed at rate TP . The net income forgone is thus $(1- TD )(1- TR )R . Against this, the additional internal funds generate a capital gain (taxed at rate TG ) that reflects the additional future net income ρ that will generate dividends (taxed at TD ). The net benefit to retaining an additional $1 is thus
Setting this to zero gives (2).
For new equity, (3) in Box 2 follows from a similar argument55 except that the initial cost is in terms of funds already in the shareholders’ hands, and so is not mitigated by the dividend tax, and there are no capital gains consequences (since the share is purchased at the a price reflecting the future earnings). Optimality thus requires
which gives (3). Imputation schemes of the kind mentioned in the text provide a shareholder-level credit for corporate level taxes charged at some rate C, so that 1-TD = (1-TR ) /(1-C); if C is set at the CIT rate, the cost of new equity is the same as that of debt-finance.
Appendix 2. International Tax Considerations
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The terms ‘tax haven’ and ‘low tax jurisdiction’ are not used here synonymously: the former has come to be associated with illegal concealment of income, the latter term is used to highlight the perfectly legal avoidance opportunities that low tax rates (and/or narrow bases) may create: see Section IV.B.
It does not however address in any detail the transitional issues that fundamental reforms would raise.
The original rationale for this was a legalistic one, the view being that the corporation is so entwined with its shareholders that payments to them should not be deductible whereas payments on debt are to true third parties and so should be. In economic terms, of course, both kinds of payment represent a return to capital, and it is their combined treatment at corporate and personal levels that matters. Shaviro (2009) discusses further.
Private equity and hedge funds are partnerships, so are taxed not at entity level but by ‘flow through’ to the partners (raising issues related to the tax treatment of the general managers that are discussed in section IV.D). Hedge funds typically do not push debt down to corporations, so this leverage issue does not arise.
In addition: (1) capital gains are often charged at a lower statutory rate the longer assets are held (as in the U.S., and until 2008 in the U.K. and Germany); and (2) in the U.S., CGT can be avoided by holding assets until death.
These were common in Europe, but have become less so in recent years, partly because of complexities in dealing with cross-border investments but also as decisions of the European Court of Justice have suggested that the Community’s nondiscrimination rules require member states to provide credit for CIT paid in other member states. Australia and New Zealand retain full imputation, and Canada partial.
Weichenrieder and Klautke (2008).
Defined, more precisely, as the proportion by which the pre-tax return on a project that the investor just finds worthwhile exceeds the post-tax return they require.
The former give the holder the option to convert to equity (and sometimes the issuer the option to call the bond), the latter pay distributions at a fixed rate but allow the issuer to defer payment.
Devereux et al (2006) report a survey of finance officers as indicating that anti-avoidance legislation adopted in the U.K. in 2005 has substantially reduced the use of hybrid entities and instruments.
Shaviro (2009) notes, for instance, that the U.S. Congress instructed the Treasury to issue comprehensive regulations setting out the tax distinction between the two in 1969: but, not for want of trying, it has been unable to do so.
Preferred securities are treated as Tier 2 capital if issued directly by the bank. If issued, however, by a trust in which the bank has an interest, which then makes a loan to the bank, the interest is deductible to the bank while Basel guidelines allow inclusion of the bank’s equity interest in tier 1 capital.
In the case of TruPS, for example, by appropriate consolidation rules to look through the trust.
Stiglitz and Weiss (1981) and de Meza and Webb (1987), for instance, derive contrasting results from different assumptions on the joint distribution of projects’ probability of success and return if successful.
There are no data on corporate leverage in Latvia during this period, though the financial and real estate sectors did become highly leveraged.
Davis and Stone (2004), for instance, find that higher debt-equity ratios are associated with greater post-crisis output declines, and IMF (2008) that the cumulative output loss following periods of financial stress tends to be larger the greater the run-up in nonfinancial corporate debt before the onset.
FAD has supported or advocated CITs with ACE features several times in recent years.
So long as the availability of a future tax reduction is perfectly certain—which requires appropriate arrangements in the event, for example, of the firm ceasing operations—the associated cash flow is appropriately discounted as risk-free. This and other issues in implementing an ACE are discussed in Griffith, Hines and Sørensen (2008).
See Klemm (2007); for Croatia, Keen and King (2002); for Italy, Bordignon, Giannini and Panteghini (2001) and Staderini (2001), the latter finding reduced debt-equity ratios consequent on movement to the partial ACE.
Debt-related deductions, for instance, could be less than interest actually paid.
If, on the other hand, the normal return is subsidized (which, as noted above, may well be the case for debt-financed investments) eliminating the distortion would increase tax revenue by more than labor income falls: taxes could be cut so as to leave labor better off and tax revenue ultimately no lower.
Since, given the dividend tax, not doing so would amount to double taxation.
One such scheme charges CGT on the excess of the actual sale value over not the acquisition price but what that price would have been had the asset earned the risk-free rate, in effect taxing only expected gains or losses while leaving the realization decision undistorted (Auerbach, 1991). This has the disadvantage that tax might be payable even on assets that had made a loss, but more complex schemes address this. Alworth et al (2003) describe experience in Italy with schemes of this broad type.
An incidental advantage of an ACE (described below) is that tax incentives to overstate specific provisions would in principle be eliminated, since any increased deduction from doing so would be offset in PV by a reduction in Tier 1 capital and hence in the future imputed tax allowance on equity.
The treatment of housing under a personal expenditure tax can be problematic. The simplest approach would be to subject new housing fully to the VAT, but this would not incorporate the progressivity of the income tax, and nor would it tax returns to housing in excess of normal. The usual way of achieving the latter would mean allowing housing purchase as an immediate deduction (with carry forward of any loss at interest) and fully taxing sale proceeds, eliminating liability for many taxpayers.
Several countries charge VAT on first sales of residences, which—to the extent that house prices are the present value of housing services—amounts to an implicit tax on imputed rents, though one that is not tailored to household circumstances in the same way that the income tax is.
Taxation also affects other features of the housing market, not considered here—including the share of housing in the aggregate capital stock.
Poterba and Siani (2008). The comparison is with an idealized personal income tax of the type described in paragraph 33.
Partly reflecting the abolition of the property tax on owner–occupation in 2008.
This provided that any gain on disposal of a house would not be taxed if the proceeds were reinvested in another property: so no tax liability arose as long as taxpayers traded up with each move.
Glaeser and Shapiro (2002), for example, note that while mortgage interest deduction does appear to increase the amount spent on housing in the U.S., home ownership rates have been broadly stable despite large changes in the tax subsidy.
Tax issues raised by securitization include: whether any gains on assets placed in the SPV by the originator are taxable; whether the SPV itself is taxable; and whether payments to holders of the securitized assets will be taxed as interest or dividends.
Investors paying tax on interest income at a rate higher than that at which they can offset capital losses benefit by pooling assets to pay interest at a rate which reflects the expected losses. Investors facing the same rate on both, on the other hand, do not care about the mix of interest and gains. Bringing the two types together creates scope for tax arbitrage from which both can benefit, with a role too for the use of CDSs. Eddin (2009) develops this argument.
Neutrality argues against taxing intermediation of this kind. A coherent approach is to treat the SPV itself on a flow-through basis, taxing instead at the level of the originator and security-holder.
Controlled foreign corporation (CFC) rules aim to preclude this by bringing passive income into tax even if not repatriated.
This is the case, for instance, with the potential inconsistencies that make possible the hybrid entity (explained in Appendix 2).
The investor may well end up bearing less after-tax risk, with increased holding of the asset more than offset by its reduced riskiness.
If denial of loss offset is used to reduce the tax rate, the increased after-tax return in good states makes the effect ambiguous.
Leasing, for instance, can be a way for companies to effectively trade in tax losses, with tax paying firms taking investment-related deductions that are then shared by leasing to tax-exhausted companies.
Subsequently reversed, though not retroactively.
The tax treatment described here is not universal, but is quite common.
This is the case, for instance, in Belgium, Denmark, Finland, France, Germany, Ireland, Italy, Spain, Sweden, the U.S. and the U.K.
See Bond, Hawkins and Klemm (2005), who examine the effects on share prices of reductions in stamp duty announced in 1984, 1986, and (though ultimately not implemented) 1990. (There have been no subsequent changes).
The marginal cost of any form of finance today typically depends on the marginal source in the future: the latter is assumed throughout this analysis to be retentions.
Portfolio income of individuals, however, is commonly taxed on a residence basis.
By, for instance, borrowing in a (high-tax) country to acquire equity in a subsidiary located in a low-tax jurisdiction that then lends to another subsidiary in a third country: see Mintz (2004).
For a firm with deficit credits—that is, which has not paid enough foreign tax to eliminate its the U.S. liability on repatriation—interest allocation has no effect: the increase in taxes on domestic income it implies is exactly offset by a reduction in the U.S. tax due on income from abroad (since that underlying income is reduced, for the U.S. tax purposes, by the interest allocated there). For a firm with excess credits, interest allocation does increase the U.S. tax payments.
Nor is that interest generally taxed in the high tax country unless it applies CFC rules.