David McIlroy tackles the taxing question of unsustainable corporate debt
The coronavirus crisis has created widespread concern about the effects of unsustainable debt at all levels of society: households without savings to absorb the shock of reduced income or unemployment will be plunged into poverty; some indebted governments forced to choose between funding healthcare services to combat the pandemic and repaying their creditors; other governments taking on debt which their taxpayers will have to pay over generations; and companies facing levels of debt which will impede economic recovery and investment in the emerging ‘new normal’.
The Jubilee Centre has established a taskforce to look at all these levels of debt from a biblical perspective. In respect of corporate debt, there are a number of proposals to be considered. This paper looks at just one: the question of how companies should be funded and how the funding of companies should be taxed.
Incentives to Corporate Indebtedness
Companies currently get tax relief on the interest payments on their debt whereas money paid to shareholders as dividends is taxed. There is no economic rationale for this tax bias, yet it persists. Robert Pozen of Harvard Business School described the tax breaks for debt as “A senseless subsidy” and a candidate for the “world’s worst economic distortion”.
The tax treatment of debt against equity has consistently given companies incentives to finance themselves as much as possible through debt and as little as possible through equity. To state the position in the simplest terms: the fact that companies are able to get tax relief on the interest they have to pay on their debt gives them a reason to borrow rather than to seek investment.
The result is that ‘our economic system is laden with debt’ - an unavoidable truth, but one which the financial and political class have sought to put out of their, and our, minds.
In 2017, Ann Pettifor reported that US corporations had accumulated $6.6 trillion in debt. Of the $793 billion by which this debt had increased in 2015, only $93 billion had been spent on capital investment, suggesting that ‘the $700 billion difference was used for unproductive, speculative activities’, namely stock buybacks.
Boeing exemplifies the sort of behaviour the tax break on debts encourages. Stock buybacks financed with debt boost earnings per share and post-tax profits from which directors holding share options benefit. Between 2013 and March 2019, Boeing bought back 200 million of its own shares (25% of the total) at a cost of $43 billion.
The result is that there are lots of companies which have a very small base of equity capital but carry very high levels of debt. The ability to use leverage to generate outsized returns for a small number of investors at the expense of other stakeholders has seen the number of businesses owned by private equity firms sharply increase since 2008. The result is that large businesses have become projects in financial engineering rather than enterprises committed to efficiently delivering the goods and services we need today and investing in developing the goods and services we will need tomorrow.
Already by 2015, at least one third of US companies had levels of debt which they could barely service. The coronavirus crisis has exposed those businesses which were recklessly indebted before the crisis struck. To bail out those businesses would be to misallocate funds and to reward corporate mismanagement. If the services those companies provide are so important they must continue, then the existing shareholders should be the ones who bear the loss and be replaced by money from new investors or, if no market solution is available, from the government in the last resort. The model here is that of the rescue of banks such as RBS, Bank of Scotland and Northern Rock during the Global Financial Crisis.
But the prioritising of debt over equity has not just affected the way in which the largest companies, able to borrow on the bond markets or to enter into bespoke arrangements with holders of capital, have financed themselves.
As Xavier Rolet argued in a 2017 article, ‘Our markets subsidise the debts of big business while starving small companies of capital’. He makes the case that debt “is fundamentally ill-suited to helping the companies best positioned to drive economic growth and create new jobs: start-ups and Small and Medium Enterprises (SMEs).”
The result is, as TheCityUK’s Recapitalisation Group notes, SMEs in the UK have managed to raise little in the way of equity finance. The average of £7.2 billion a year between 2017 and 2019 is 30% of the total already lent under the UK government’s bounce bank loan’s scheme. Equity finance is therefore a very small, and proportionately diminishing, source of capital for small businesses.
Debt and Risk
The Jubilee Centre has argued for a long time that from a relational perspective, investment is preferable to borrowing because investors’ incentives are more closely aligned with those of the business than are those of a creditor. The investor and the business share the risks of failure and the rewards of success. The result is that an investor is far more likely to support a business through a difficult period of trading than to take a short term decision to realise its capital.
Debt, by contrast, places the vast majority of the risk on the borrower, with the lender (particularly if they hold security) with many more options if the borrower cannot repay the loan on time or at all. Debt creates fragility. The fixed repayments mean companies focus on surviving from day to day rather than planning for the long term. Debt, unlike equity, amplifies the effects of economic downturns.
This is the fundamental flaw in the UK government’s response to the coronavirus crisis. Companies have been loaded up with levels of debt which would be unthinkable were interest rates not close to zero.
More than 780,000 small businesses have taken on bounce back loans totalling £23.8 billion, just under 50,000 businesses have been lent a further £9.6 billion under the Coronavirus Business Interruption Loan Scheme (CBILS) and another £1.56 billion lent to 615 businesses under the Coronavirus Large Business Interruption Loan Scheme (CLBILS).
TheCityUK Recapitalisation Group’s Interim Report, published on 8 June 2020, warned that unsustainable debts would impede the UK’s recovery. The report, chaired by Aviva chairman Sir Adrian Montague and supported by Ernst & Young, predicted that by March 2021, UK businesses would have around £100 billion of unsustainable debt, approximately half of which would be owed by SMEs. Of that £100 billion, about one-third would have been accumulated as a result of the UK government’s Covid-19 lending schemes.
The economic case for treating equity at least as favourably as debt
The capital to invest does exist. Institutional investors had, at the end of 2019, cash and liquidity reserves of more than $140 trillion. The current structure of laws relating to tax and security encourage those investors to spend the money on debt instruments and property, rather than investing it into businesses as equity.
The present crisis is also a moment of opportunity. To do nothing would be calamitous, but there is a choice to be made between levelling the field between equity and debt either upwards or downwards.
An example of the levelling down approach is offering tax relief to those “angel investors” who invest in start up companies. 88 businesses, led by law firm Buckworths, have written to the Chancellor of the Exchequer asking for angel investors to be given temporary tax relief under the Enterprise Investment Scheme for matched funding under the UK Government’s Future Fund Scheme. The risk, says the letter, of not doing so is that a generation of SMEs will be lost. The proposal has the merit of shifting the risk of lending to SMEs away from the government (which has incurred substantial contingent liabilities under the various debt-based schemes it has introduced) and onto the shoulders of investors. However, it amounts to a targeted, temporary measure rather than a fundamental change to the system.
A levelling up approach would make interest payments taxable on the same basis as shareholders’ profits or, better, to abolish tax relief for interest payments entirely. Now, with interest rates so low, there is an unprecedented moment to make the change. Abolishing tax relief would allow a reduction in the level of corporation tax because of the larger tax base. Doing the two measures in combination would distinguish between the sheep and the goats: overly indebted companies would need to be re-structured through insolvency; those businesses which are viable would be incentivised to look for equity investment to fund their recovery.
Now, even more than the Global Financial Crisis, is the time for us finally to come to terms with the reality that our debts are unsustainable and that fundamental reforms to risk-sharing and to taxation in our society are required in order for businesses and the households they serve to flourish.
David McIlroy is Visiting Professor, CCLS, Queen Mary, University of London, and a barrister at Forum Chambers. He's the convener for Jubilee Centre's post-coronavirus task force on debt.
Find more resources from the debt post-coronavirus taskforce.
 Pozen, ‘Ending the debt addiction: a senseless subsidy’, The Economist, 16 May 2015. The argument that debt should not be favoured over equity was advanced by economists F. Modigliani, and M. Miller in 1958. "The Cost of Capital, Corporation Finance and the Theory of Investment" American Economic Review 48(3): 261–297.
 Ann Pettifor, The Production of Money: How to Break the Power of Bankers (London: Verso, 2018) 73.
 In 2000, William Lazonick and Mary O’Sullivan were already identifying the productivity decline and damage to long term economic prosperity this misallocation of resources is causing: ‘Maximizing shareholder value: a new ideology for corporate governance’, (2000) 29 Economy and Society 13-35.
 Ann Pettifor, The Production of Money, xi-xii.
 M. Schluter, ‘Beyond Capitalism: Towards a Relational Economy’. See also Michael Schluter, ‘Is Capitalism morally bankrupt?’, Cambridge Papers, Vol. 18, No. 3, Sept 2009 and Andrew McNally, Debtonator: How Debt favours the few and Equity can work for all of us (Elliot & Thompson, 2015).
 Ever since the First Basel Capital Accord, banks (followed by other financial institutions subject to capital adequacy requirements) have been perversely incentivized to fund property rather than to invest in businesses. Existing and proposed changes to UK corporate insolvency laws are likely to further increase the appetite of institutional investors for property (probably residential rather than commercial) over lending to businesses.