The Debt Bias: Or, how good reforms do bad things to good people

I’ve been reading a lot of economic commentary and analysis around two things lately: (1) is, naturally, the negotiations surrounding the “fiscal cliff,” and (2) is Prof. Anas Admati’s argument that the best financial reform we could undertake would be to require banks to have a higher equity ratio (that is, to finance more of their assets through stock and less through debt, reducing their leverage). I hope to write at greater length about (2) in the future, but, for now, suffice it to say that both of these things center on the “debt bias” in the U.S. tax-code, a bias which piqued my interest and so which, after a little research, I should like to tell you about.

Let me start out with some econ for poets. Suppose you’re a business and you want to make a big expansion–setting up lots of new stores, opening a new R&D facility, etc.–that will cost you $1 billion.  Unless you have a lot of cash on hand (which you probably shouldn’t–it would have been wasteful to have just accumulated it) there are two ways you could fund this expansion. One, you could issue more shares in your company (that is, sell more stock to the public)–this is equity. Or, two, you could get a loan from a bank to do this–this is debt. Which option should you choose? Well, naturally, you should choose whichever one is cheaper–technically, whichever funding option’s obligations have a lower net present discounted value (the debt’s obligations being interest and principle, and the equity’s obligation being a share of profits and ownership). In reality, which one will be cheaper? Well, theoretically, since these two instruments are both providing the same good–financing–they should be about equally expensive. Think about it: if interest rates were relatively high, meaning that debt was more expensive than equity, firms would rush to issue more shares, which would reduce stock prices by increasing their supply, and eschew bank loans, which would force banks to lower their ‘prices’ (their interest rates), until the two became equally expensive. So in a perfect market, equity and debt should be about equally expensive for companies, and companies would make their financing decisions as follows:  they would fund their activities through equity if they thought that their shares were slightly overpriced, and through debt if they thought their shares were relatively underpriced.

Now, we’ve just done some typical Econ 101 theory above, about an ideal market. But in the real world corporate financing decisions are distorted. One major distortion is the U.S. tax code, which includes a deduction for interest payments on debt. The tax code does not include a deduction from dividend payments to shareholders. To the contrary, corporate profits returned to shareholders are taxed twice: once as corporate profits (just before they have been returned to shareholders), and again as capital gains (once they are in the shareholders’ hands). What does this do? Well, it gives companies a strong “debt bias” relative to the ideal market we laid out above. Because the obligations they incur from debt-financing in fact reduce their tax burdens, corporations are incentivized to rely relatively more heavily on debt, and less on equity.

Why is this a problem? Well, it isn’t always, necessarily, a problem for everyone. Indeed, if you’re a shareholder of a firm that has really great growth prospects for the future, you should be happy with debt-financing–this “leverage” means that you will get a higher share of whatever is left over once debt-obligations are paid off, than if your share had been diluted by the issuance of more equity. But the problems are twofold. First, in general, we as a society want companies to devote their analysis to trying figure out, and their energies to trying to meet, our needs as we express them in the marketplace–not make their decisions based on how best to game the tax code.  But, second, debt becomes a very big, very tangible problem during an economic downturn, when it can cause a credit crunch, a massive financial crisis, and thence a recession/depression, as you may have heard. We often hear debt analogized to “leverage,” because it makes the good times better for companies’ owners (shareholders) and the bad times worse. Consider this super simplified model of a firm buying one asset in one year, with a 2% interest rate: If you’ve financed a $100 million asset through $50m of equity and $50m of debt (a debt-equity ratio of 1 to 1), if the value of that asset suddenly declines to $85m, you’re still easily okay–you can pay back your creditors their $51m, and still have $34m left, which is now the value of your shareholders’ stake, a loss of $16m for them. But if you financed that through $10m of equity and $90m of debt (a debt-equity ratio/leverage of 9 to 1), the same decline in the asset’s value will bankrupt you: You owe creditors more than you have, and so your shares are worth less than nothing, and you have to enter bankruptcy. If you get the conceptual gist here, you can probably also see how, in good times, when firms are making high profits, “leverage” (a high debt-equity ratio) can increase the profits that are returned to shareholders. (But, and this is a bit technical, it does not technically increase shareholder value, because the leverage makes the expected return-on-equity riskier.) It also makes it much easier for firms to slip into bankruptcy when the times are not as good as they had predicted.

So what, then, is the problem with leverage if it just helps shareholders on the upside, and hurts them or causes bankruptcy on the downside? Why should I care if I’m not a major shareholder, or involved in any way with a highly-levered firm? Or if I am a shareholder, shouldn’t I be okay with this as long as I have a diversified portfolio that is collectively non-risky? The problem is that, during a credit crunch and financial crisis, bankruptcy is contagious. That is, when a highly-levered firm (which could itself be a bank–see my upcoming post on Admati) can no longer meet its obligations and enters bankruptcy, it is failing to pay out a cash flow that a bank had been depending on to finance its own activities. So that can send that bank into bankruptcy, or leave it unable to roll over the debt of another firm, sending that firm into bankruptcy. This is basically what a “credit crunch” is–everybody being so indebted to everyone else, that a small economic downturn can cause a string of interlocking insolvencies–and this is pretty much the story of what has happened in the economy from 2007-present. If companies had had less debt, and financed more of their activities with equity, an economic downturn would have caused their shareholders to take an unpleasant hit, but it would not cause this contagious domino-effect of insolvency.

A lot of what I’ve written about firms is also true of people, except for the fact that we people don’t really have the option (yet) of getting outside equity-financing (though some are proposing to equity-finance college loans–more on this later). For example, we humans have a mortgage-interest deduction, which provides us an incentive to take out relatively larger mortgages on our homes. There are a couple of problems with this. First, since the real-estate market is in reality largely an arms-race to get into the best school district possible, people generally buy the most expensive house they can afford, and so, according to many economists, the economic value of the mortgage-interest deduction is simply capitalized in higher home prices–i.e., in the aggregate, it doesn’t provide any easing of financial burdens to homeowners at all. Second, it distorts the market for buying vs. renting property–and there’s no particularly compelling reason to do that. And third, and most importantly, as we, again, saw in the financial crisis, more debt makes it easier for you to get wiped out by even small changes in the value of your assets. Suppose bad employment prospects have made it difficult for you to make your mortgage payments–if, in addition, the value of your house has declined, leaving you “underwater,” you won’t be able to refinance your house, and so you’ll default. That will reduce the cash flow to the bank that is entitled to them which, in turn, can cause Lehman… You get the picture. So personal bankruptcies, just like company bankruptcies, are contagious, and they become likelier and more harmful the more debt we all have.

***

I hope that you, gentle reader, do not spend as much time reading economics commentary as I do (because then what use would I be to you?), but one thing I’ve noticed is that almost all econ-theory minded people want to get rid of all of these distortions. Everyone seems to agree that the ideal tax reform involve lower rates, while getting rid of loopholes and deductions, such that we can actually raise more revenue, while imposing fewer distortions on the marketplace. There’s a consensus among them. But if there’s a consensus, why can’t we get some policy and legal changes done? The answer, of course, is “vested interests.” But that term sounds mean, and derogatory, and, more importantly, it understates the difficulty of our challenge.

Because, in this case, the term ‘vested interests’ doesn’t just mean super-rich super-evil tobacco lobbyists, or some such fun-to-hate villain, but actually literally means your mom and dad. Even if your mom and dad have already finished paying off the mortgage on your house, getting rid of the mortgage-interest deduction would hurt them, because it would reduce the sale-value of their house, because it would hurt the real-estate market as a whole (since new buyers won’t get such large mortgages if they can’t write them off). And the same goes for the corporate interest deduction–if we eliminated it, a lot of medium-size firms would  lose a lot of money when they can no longer write off the interest on bonds they issued a decade or two ago. And the same goes for a lot of other loopholes:  if we get rid of the federal deduction of state income taxes, medium-high-income people in high-tax states are going to get badly hurt. All of these people were, when they made these decisions, responding rationally to the incentives our public polices had put in place. They formed rational expectations for the future based off of those expectations. They were good people doing the right thing, in the circumstances and policy landscape that they were presented with, and now the policy changes that we are proposing are going to hurt them and disrupt the life path that the old policies had led them to expect. These people are, quite justly, going to be very upset if their representatives do it.

This is why reform is hard. 

Nonetheless, I’ll reiterate that we really should do the right thing and eliminate these distortions and tax loopholes if we can. It would obviously be wrong to leave bad policies in place forever. But the longer we leave them in place, the more and more good, rational, reasonable people build their lives around those policies, making them even more costly to be rid of in the future. So the very best time to take the plunge is right away.

27 thoughts on “The Debt Bias: Or, how good reforms do bad things to good people

  1. I agree with a lot of what you said and never thought about the debt bias in this way before, so thanks for the food for thought on that. I do think that you give too much credit to rational thinking though – but of course bringing up the emotional component would complicate your theme here. Worth addressing, though.

  2. So where did the bias towards debt initially come from?
    I get that with these rules in place, most players are just more or less acting rationally in their best interest – but whoever came up with the rules in the first place?

    • It’s not that bad unless you fall over the edge and drop into the bottomless pit and then have to pick yourself up and start climbing that vertical cliff that soars thousands of sheer feet to the edge.

  3. Good blog. Everything that you have pointed out is true. But you left a very important question that would be arguably the root cause for the credit crunch. How did we have all these consumers, businessmen and investors alike commit the cluster of errors we saw in the credit bubble? The answer is through irresponsible monetary policies. Perhaps fiscal reform may be hard because politicians are so engraved with their constituents and donors. But no one talks about monetary policies in the news. And if they do talk about it, it doesn’t get the attention it so desperately deserves. The fiscal cliff is only a symptom to the disease of this debt-financed-consumption.

  4. A sudden thought: taxes aren’t the only incentive for a company to finance via debt rather than via equity. If economic theory predicts that firms will finance “through debt if they [think] their shares [are] relatively underpriced,” then financing via debt sends a positive signal to potential investors, while financing via equity sends a negative signal. For a non-massive company, it may be the case that interest rates are more or less independent of its financing decisions while its share prices are not.

    Accordingly, if a company attempts to finance a greater and greater percentage of its new investments via equity, its market share price may drop considerably. if that happens debt financing becomes increasingly attractive. A 1-to-1 debt-to-equity ratio may not then be in the firm’s short-term economic interest, even if the tax incentives you describe are done away with.

    Is there something wrong with this reasoning? This (wannabe) behavioral economist is completely out of his depth in finance.

  5. Rational thinking could be an over-statement. Rational thinking takes quite some time and the way the market is set up for quick buying and selling, thought is squeezed out in favor of a knee jerk reaction. Historically speaking thought has been given a bad rap, making it in reality sinful to do so, this creates an atmosphere of the faithful in favor of those who think on how to get the best from those who rely on that knee jerk reaction…Great article, being laymen as myself you certainly made it come to life. In 2007 I started a few paintings , reactions to the way the market was mutating and as the stories come out those paintings are dead on! Thank you for your commentary !

  6. Thanks for this post! I teach history and government on the high school level, and next year I’ll be teaching economics. So now I’m following your blog! As you probably already know, the Boston Tea Party wasn’t actually a revolt against taxes, it was a negative reaction to the British government subsidizing the British East India Tea Company, which the American colonists viewed as a fundamentally unfair government action in the market. Learning this more accurate version of the Boston Tea Party has really made me want to look deeper into economics, and now here I am on your blog! An answer to my wonderings! :)

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  8. fyi, in Indonesia the distortion also came from government monetary policy, printing money as fast as they can, M2 growth around 20% p.a., cost of debt only 10% p.a., deposit rate only 5%, hence using debt is a very viable strategy, you get subsidy from the depositors

  9. Many thanks for a great post. I consider myself relatively well informed on economics, but this is still a big help – you really spell it out here. You’re the Bill Clinton (at the 2012 DNC) of the freshly pressed!

  10. I agree with what you say, except that I am in favor of businesses and individuals having savings and doing as little as possible with credit. I can’t evaluate huge corporations, but I know several local business owners. The ones that went out of business or barely stayed open were the ones who were carrying high debt when the recession started. The couple of companies I know that did pretty well during the recession (and both are doing fine now, though both are very concerned about ObamaCare’s costs) were the ones who had very little debt AND also fairly large reserve funds. Similarly, the individuals I know who did poorly in the recession entered it carrying large amounts of debt (whether mortgage or unsecured) and the ones who did fine already had nice savings accounts, credit cards they never touched and a house they could easily afford.

    I’m not sure it’s a waste for that company to have that reserve fund. Yes, it may seem like less than optimally productive money, but it also provides a buffer for hard times.

    And, yes, I think the tax credit on debt does distort businesses and individuals toward carrying more debt ;than is prudent.

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  12. Very good information about distortions. The effect of tax policy on individual and business decisions is indeed important. But I think we (and especially business people) exaggerate the influence of tax policy. Business people often use it as an EXCUSE for bad behavior.

    In my long experience in life, if there is money to be made by selling a product or service, established or new businesses will find a way, by hook or by crook, to supply that product and make a profit. Forget about some little tax incentive or disincentive. The government can positively prohibit a product, with heavy penalties for breaking the law or regulation, and entrepreneurs will still boldly market the product. Cases in point: alcohol during the Prohibition era, and marijuana, heroin and cocaine during the “war on drugs” era.

    Corporations are sitting on cash right now, and businesses are refusing to invest and expand, for one of two main reasons: Worldwide and domestic DEMAND is low, because consumers have no money, or worldwide SUPPLY of many commodities and manufactured products is already sky high.

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  15. I was wondering if you ever thought of changing the
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