Stop Bribing Companies to Lever Up

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Go ahead and pull out an income statement for your favorite stock. I'll wait.

You'll notice that there is a line called "Interest Expense" that comes before the "Tax Expense" line. Now notice the absence of similar lines for "Dividend Expense" and "Share Buyback Expense."

No, I'm not trying to bore you with an accounting lecture. I'm trying to point out a travesty of modern finance: the unequal treatment of debt and equity, better known as the tax-deductibility of interest.


Thanks to interest deductibility, our tax code unfairly benefits companies that lever themselves to the moon -- e.g., big banks -- while putting those who choose equity financing -- like Apple (NAS: AAPL) -- at a comparative disadvantage.

And the disparity is real. The Congressional Budget Office finds that equity-financed corporate investments pay an effective tax rate of 36.1%, while debt-financed investments pay an effective tax rate of -6.4%.

Yes, that's a negative tax rate for debt-financed corporate investment. Taxpayers are paying corporations to lever up. It's totally unfair and unwise.

And then we all sit around and wonder why banks levered themselves 1000 to 1. Why, the tax code pays them to!

Corporate welfare for borrowers
One of the lessons that business school students learn is that you should, generally speaking, use debt if it's not totally reckless. This is because if I borrow money at, for instance, 6%, I'm not really paying 6%. Thanks to Uncle Sam, I'm paying 3.9% after taking into effect the "tax shield" of deductible interest expense, assuming a 35% corporate tax rate.

Think of it as welfare for corporate borrowers. And in the case of Goldman Sachs  (NYS: GS) , it saved the company $2.2 billion last year -- the majority of its net income. Goldman was not alone: The deduction saved Citigroup (NYS: C) $5.8 billion, which was the majority of that company's net income, too. The same is true for highly levered nonbank stocks like DineEquity (NYS: DIN) , owner of the Applebee's and IHOP franchises. 

The majority of their net income is all paid for by the tax code.

The picture isn't as rosy for companies who use equity instead of debt. If I issue equity with a required rate of return (to compensate for the risk) of 10%, I end up "paying" 10%. The government does not subsidize my equity issuance via a deduction, nor are share buybacks or dividend payments (whose potential determines a stock's value) tax-deductible at the corporate level. My 10% stays 10%.

Now, there's been a lot of bluster in Congress about the evils of leverage. It seems to me that the obvious step forward would be to -- oh, I don't know -- stop paying people to take on leverage?

Just a thought.

The FairTax solution
One of the objections a reader might bring up isWHERE  that interest payments are taxed --via the recipient's income. This is true.

But so are dividends. However, dividends are also taxed at the corporate level (as earnings), too. So dividends get taxed twice, and interest gets taxed once. Therefore, the playing field is still skewed toward debt. (Share buybacks are taxed only once, but at the same, generally higher corporate-level tax rate as earnings.)

A way to fix this would be to simply eliminate the interest deduction in exchange for a lower corporate tax rate, as President Obama proposed back in February.

Alternatively, we could go for fellow Fool Dan Caplinger's proposal and simply eliminate the corporate income tax. If the tax rate is 0%, getting a deduction for interest expense doesn't matter.

The problem with both of these proposals is that they might send the pendulum too far in the other direction. If dividends are taxed at 15% with a lower corporate tax rate (0% in Dan's case) while income and interest are taxed at up to 35%, we may have simply skewed the field in another direction -- toward equity. This goes double when you figure that share buybacks are only taxed via the corporate tax rate. So you could wind up with the opposite problem.

I think a more comprehensive solution is in order. And that solution is moving to a consumption-tax-based system like the FairTax.

Under the FairTax, the corporate income tax, dividend tax, capital gains tax, payroll taxes, and individual income taxes (including any taxes on interest) would be completely eliminated. Instead, a national sales tax of 23% would be levied on all new goods and services. An "advanced refund" mechanism would also be put in place to ensure that the tax does not hurt those below the poverty line. I'm not the best one to explain the details, so I recommend checking out the FairTax website.

If nothing is taxed besides sales, there can be no perverse tax incentives to lever or delever. Debt and equity are truly on an equal footing, as they should be.

If you think I'm a crazy libertarian sporting rose-colored glasses, you haven't been reading my columns as of late. I've been very supportive of stimulus spending, the TARP "bailout," and Ben Bernanke's Fed -- all stuff that has me on the libertarian hit list.

But I know a good idea when I see one.

The article Stop Bribing Companies to Lever Up originally appeared on Fool.com.

Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by @askchrisbainesChris' stock picks and pans have outperformed 96% of players on CAPS. He owns shares of Berkshire Hathaway. The Motley Fool owns shares of Apple and Citigroup Inc. Motley Fool newsletter services recommend Apple and Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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