Reihan Salam makes a very important point, that the incentives we’ve put in place have the perverse effect of creating fewer jobs than might otherwise be the case:
As it turns out, the U.S. tax code does give large incumbents an enormous advantage over start-ups by subsidizing corporate debt. When businesses want to raise money for operations, they can pour their profits back into the business, they can sell shares or they can borrow. In an ideal world, we’d want business enterprises to make these decisions on the basis of what makes the most sense based on underlying economic conditions. But in the United States, we allow companies to deduct interest expenses from their taxes but not dividends on their stocks. This makes it far cheaper for companies to raise money by borrowing than by selling shares.
One reason this debt bias is a problem is that it leads companies to take on large amounts of debt, which raises the risk that they will go bankrupt. Yet there is another problem: It is much easier for some companies to borrow than for others. Specifically, well-established firms ‑ for example, large incumbents with pricing power that have been around for years ‑ find it much easier to borrow than new, unproven firms with high-growth potential, which have little choice but to rely on selling shares to finance investment. And so the tax-deductibility of interest expenses and not dividends gives the entrenched corporate Goliaths that have the option to borrow a big boost, while doing nothing for the would-be corporate Davids eager to take them on.
He goes on to propose imposing a cap on the amount of interest a company could deduct for purposes of calculating its corporate income tax. That should be an approach that would be acceptable for those for whom the moral necessity of increasing the amount of revenue derived from the corporate income tax is an article of faith. There is, however, an even simpler, less distorting, and more effective strategy for realigning the incentives that favors more growth and more employment: abolish the corporate income tax completely.
While I’m also in favor of eliminating the corporate income tax (or better yet, replacing it with a carbon tax), I’m skeptical doing so would have all that much impact on growth or employment. It’s mostly a joke at this point.
http://marginalrevolution.com/marginalrevolution/2011/11/corporate-income-tax-as-a-share-of-corporate-profits.html
Oh my. This is why friends shouldn’t let friends………write inane things.
I hadn’t heard of Salam, so I looked him up. If its the same guy (I’m sure it is) then he has good intentions – he’s a small business advocate – but this is just a mess of misunderstanding and wrongheaded thinking, the poor dear. In the link I saw the references to college professors. I have no doubt their motivation: more taxes.
For any interested readers, I’d like to comment in two parts. The first a brief tutorial on financing and cap structuring. Just the rudiments, because it lays the groundwork. Second, why this guy is so misguided. As a preview: We will end up with Dave’s suggestion.
Financing
Companies raise financing and the result is called its “capital structure.” It is reflected on its balance sheet. There can be simple or complex capital structures with multiple components or layers. The guiding principles are risk and reward, and what investors seek. So….
The first claim on a corporation’s net cash flow from operations or liquidation is the “senior secured debt.” Senior because it gets paid first; secured because they have a lien on the assets. (The guys Obama screwed at GM) They get paid first, but they get paid the least return. Then come various other forms of debt, if existent: unsecured senior debt, subordinated debt, jr subordinated debt. The corporations cash flow really just flows down a waterfall and as the rights to repayment fall deeper into the cap structure they demand a larger return. (For example, for a large corporation, jr subordinated debt often gets labeled “junk bonds” etc) Then might come preferred stock, and at the bottom of the cap table comes common stock. Risk-return. The farther down the cap structure, the greater the risk of getting your money, and the greater the return expected and demanded by capital providers. Of note, all forms of debt and preferred stock (unless they have equity conversion features, which they might) is “metered money.” Tick, tick, tick……it gets paid by the hour. Any portion of a security’s return represented by equity conversion features fall into the bucket with common equity. Of course all the upside – the potential bonanza – goes to the common equity. Not metered, the residual spoils.
Before we move to the article, we need to cover credit. You only can raise debt financing, as opposed to resorting to equity, if the low metered money, and fixed, return is satisfied with the creditworthyness (is that a word?) of the enterprise. Would you make a loan to a business if you thought you would lose it all if it didn’t work, but if it did you got 6% and the owner walked off with all the loot? No! You might as well own the business yourself.
This is all a bit stylized and simplified, but you should get the idea.
I suspect Dave, ice and Steve V know all this. Others (and its not a knock) I’m not sure. But if you really get it, you will understand my amazement at the ridiculousness of Salam’s piece, and his I’m sure completely dishonest professors.
The Article (this is going to get ugly)
“As it turns out, the U.S. tax code does give large incumbents an enormous advantage over start-ups by subsidizing corporate debt.”
Pure, unadulterated crap. Start ups are not creditworthy – period. (Unless you of course are wasting the taxpayers money on loans to soon to be bankrupt solar ventures. Heh. Obama and Chu Capital Partners. Has ring. I pity the fools who gave them capital committments. Oh, wait. It was the taxpayers. ) Debt for start ups has nothing to do with the tax treatment of interest.
There are two arms of private equity. Late stage, which is what I do, and early stage (start ups) which is venture capital, angel financing, single entrepreneurs etc. Most businesses are cash flow negative early on. They can’t attract debt financing. That’s why they tend to do multiple rounds of equity financing for the first few years. AT BEST, or after a period of time, they can attract asset based loans (based on secured hard collateral values and usuually personal guarantees – heh, up until GM the safest loan – see why I’m so pissed at what Obama did at GM for his union buddies????? You want to support nacient businesses?? Don’t do what Obama did, the finance buffoon. And don’t go on about taxes on interest.) It is rare indeed when a “character loan” is made based upon the entrepreneur, not the business. We could stop there – its game, set and match. But wait! There’s more!
“In an ideal world, we’d want business enterprises to make these decisions on the basis of what makes the most sense based on underlying economic conditions.”
They do. I would have rephrased to say “underlying financing realities.” Meaning credit standing and investor appetite.
“But in the United States, we allow companies to deduct interest expenses from their taxes but not dividends on their stocks.”
There is some truth here, but then a bizarre statement. Yes, interest is deductible. So yes, you could increase the cost of debt capital to corporations. Investors have already made their decision – they will give you debt capital at x return. Quiz: what will happen if tax deductibility is eliminated?
But the second half of the statement makes you shiver. I don’t want to dive too much into the weeds, because several complex issues come into play. A dividend is a return of capital, not purely the cost of metered money (interest, not principal), given the difference each security plays in the cap structure this is meddling by no-nothings of the first degree. (As an academic argument you could have prefferred vs jr debt debates)
“One reason this debt bias is a problem is that it leads companies to take on large amounts of debt, which raises the risk that they will go bankrupt.”
Wrong, wrong and wrong. Otherwise everything is great. Debt service is defined as both principal repayment and interest. Lenders factor this. More broadly, fixed charge coverage covers other, well, “fixed charges.” Lenders factor this. Further, bankruptcy risk for start ups is astronomically more likely for start ups, even for all equity financed, than debt using established corporations. A finance man this guy ain’t.
“This makes it far cheaper for companies to raise money by borrowing than by selling shares.”
Well, duh. That’s the whole point. Minimize the overall cost of capital and appeal to the various interests of capital providers. Do you all want your entire portfolios in equities???
“Specifically, well-established firms ‑ for example, large incumbents with pricing power that have been around for years ‑ find it much easier to borrow than new, unproven firms with high-growth potential, which have little choice but to rely on selling shares to finance investment.”
Again, mind numbing. Risk-reward. Take a first course in investment, dude.
OK, I’ve had my fun. Look, this guy is probably a fine, well intentioned fellow. But he is a corporate finance and investment moron. The real thing that bothers me is that this is the sort of tripe that makes it into the national conversation. His bio says he is routinely on Maddow’s show, MSNBC in general and so forth. I’m sure there are many that watch cheering him on who have absolutely no idea that they are exposing their profound ignorance, and more importantly, hurting the very people they will tell you with all sincerity they want to help: the little guy. (And the professors? They know all this. They are dishonest f-sticks preying on the ignorant to make tax increase arguments.)
This could all be fixed. Take all the tax crap out of it. Eliminate all the complexities of corporate finance and eliminate the corporate income tax, and let tax incidence fall where it may.
As always, Drew, your ‘tutorials’ are full of common-sense information. Why isn’t there more of that in the world, and especially in governments leading the world?
sigh……..
This is OT, but I read this blog piece this morning before driving the I 5 to L.A. It’s kind of funny and pathetic at the same time, in describing the latest Three Stooges confirmed in the Obama Administration: Hagel, Kerry and Lew.
The Weekly Winston: Obama Boneless Wonder Edition.
There is just no respect going for these three guys: Hagel is like a fish out of water; Kerry can’t even get a call-back from the Russians for a full week, and is snubbed by Egypt — the latest Rodney Dangerfield in government; and Lew is cagey, corrupt and disliked by many in the Congress. Go figure how these men will help expedite better policies or relationships in this country.
*dishonest f-sticks*
I’m going to steal that.
…
jan, much of what our ‘leaders’ do makes more sense if you look at their actions and ignore their words. Words are smoke and mirrors at worst, emanations and penumbras at best. Bullshit almost all the time.
… Lew is … disliked by many in the Congress.
Normally that would count as evidence of good character.
Hagel is a fairly conventional Republican, except that he criticized the Iraq war. Read Joyner rather than Rubin. Read Larison. You need to separate out smear campaign from facts.
Steve
Back on topic, I think Drew is mostly correct but sort of misses the forest. If it is cheaper to finance through debt, companies will finance through debt. As Dave said, incentives matter. If they need debt, and bankers are convinced they can offer risk free loans, we know where that goes. We will get too much of it as both lender and borrower have the incentive to underestimate the risk. I think there are other, better reasons to eliminate the corporate income tax. Just add this one to the list.
Steve
steve
I didn’t miss any forest, or trees. Let me make it shorter.
1) The desired job creating start-ups are not debt financed. So close to to never to say never. Hence, the tax treatment of debt capacity available to large corporations is irrelevant to the job creation process, which is what Mr. Salam posited. Period, full stop. Throwing more gasoline on the fire, going up the corporate size/maturity totem pole a bit. Rather modest sized corporations – $30MM to $200MM in revenue – have quite considerable ability to take on debt. I could go out and put 3-5x cash flow (or 50% to 70% of the cap structure) on these companies any day. Oh, that’s right, I do! I don’t know many billion dollar corporations who do the same. So who’s got the better ability to raise debt? BigCo or Smallco??
I suspect what really happened with Mr. Salam is that he intuitively has concerns about the ability of large, politically powerful corporations to bend all manner of government regulation or taxe code to their favor. So do I. I write about it all the time. I also suspect that he was seeking the academic “air cover” of these profs. But he picked the wrong example and his whole analysis came to a grinding mess.
2) As for who misses to point, actually you do, steve. Debt is always cheaper for a given corporation, but they don’y completely debt finance. You ought to ponder that. And there are no risk free loans. You learn that the hard way. I admittedly just sat in the weeds to see if anyone would tumble to the correct way to look at the issue of tax deductibility of interest, suspecting no one would because of biases.
At the end of the day the deductions from revenue to arrive at taxable income are the three main inputs facilitating output: a) labor, b) cost of capital, and c) production inputs (raw materials, energy etc). No one questions deducting labor expenses. No one questions deducting raw materials or the light bill. But why question interest expense? (the answer lies in accounting convention, not economics, but I’m trying to keep this shorter than last night) The real question to be asked is why dividends are NOT deductible, not why interest expense is. But we all know the answer, debt has a bad connotation and when people view the world through the lens of more taxes they advocate acctg treatments for more taxes, and politicians view it through the lens of power and goodie giving.
As everyone seems to have correctly concluded better to avoid a taxless GE and a demogogued oil and gas industry by eliminating the corporate income tax altogether. Don’t hold your breath.
Here is a famous little teaching device about cap structure that makes some salient points:
The XYZ Corporation makes widgets. A billion a year in revenue to be exact. And they make operating profit of $150MM per year. Financial analysts place the prevailing market multiple for widget makers of this type at 8x. So the enterprise is valued at $1.2 billion. As it turns out the chief financial officer of the company is a financially conservative type who has capitalized the company with a bank loan at 5% interest for 10% of the cap structure, and the balance common stock. He spends most of his time having trysts with his secretary. Tragically, one night at the No-tell Motel in a moment of passion he has a massive heart attack and dies.
The company hires a new CFO who immediately issues a series of bonds at 7%, 9% and 10% with debt now at 50% of the cap structure. The cash is paid out to the common stockholders. For his efforts he approaches the CEO and asks for a bonus. Questions:
1) How big a bonus should he receive for increasing the enterprise value of the company, what with that cheap debt?
2) Would someone who buys stock after the recap from an existing stockholder get a superior equity return after the recap?
3) What is the effect of taxes on those questions.
4) Is the new CFO going to get some leg?
Anyone who can answer the questions “gets it.”
Drew, Salem is a right-of-center Conservative/Republican that blogs at the National Review. He is very wonkish, not libertarian and practical about advocating policies that he thinks could either pass or would benefit the Republican party in advocating. I’ve seen him on MSNBC and he advocates “conservative” solutions to problems liberals want to solve with more regulation or more spending, though he is willing to play with the tax code more than flat-taxers would. I suspect he either believes elimination of the corporate income tax is a non-starter politically or that the loss of revenue would worsen the deficit such that it would put the U.S. on a long-term track to overall higher taxes and government dependency.
“Start ups are not creditworthy – period.” I think that undercuts the significance of the competitive advantage for large firms, but I don’t know if it eliminates it. Salem explains on his own blog he may be exaggerating the effect of eliminating the subsidy for debt, that he thinks we also need regulatory and patent reform, and that could also reach the same position by subsidizing equity.
Wait, the new CFO just paid out almost six and a half years worth of profits as dividends by quintupling the debt load? Sweet.
As for how much he should get paid, that really depends on the stock options he negotiated when he was hired, doesn’t it, particularly on the dates of the options?
Stupid math error: the new CFO more than quintupled the debt. I spend too much time with two year-olds to do math, even simple math.
“At the end of the day the deductions from revenue to arrive at taxable income are the three main inputs facilitating output: a) labor, b) cost of capital, and c) production inputs (raw materials, energy etc). No one questions deducting labor expenses. No one questions deducting raw materials or the light bill. But why question interest expense? ”
Then,
“debt has a bad connotation and when people view the world through the lens of more taxes they advocate acctg treatments for more taxes, and politicians view it through the lens of power and goodie giving.”
In what sense are the deductions mentioned not “goodie giving”, or, more simply, what should businesses get any tax breaks at all?
Why? Why do people on opposites sides of the borrowing have incentives to underestimate risk?
Sorry, I’ve forgotten what little I knew in this area, and years out of work have degraded skills further.
I think I was right the first time, in that debt has quintupled. Share values should be reduced about 45% in that case. The difference is that shareholders are getting the difference in having about 3.2 years worth of profit paid out to them immediately. Bond holders gobble up the lost equity, of course.
However, that comes at a cost, and not just in reduced share value. Higher debt payments also mean in the future shareholders will get a lower equity return, at least until the bonds are paid off. Shareholders at the time of the increased dividend get a definite reward, however.
I believe that the tax situation of the company should get better under the current tax system because they’ll have more interest deductions they can take. Shareholders at the time of the balloon payment might get bumped into a higher bracket depending on their particular situation, but assuming we’re just talking BSDs and institutional investors that isn’t really a concern.
The tax situation will somewhat make up for the lower equity return going forward, but particulars probably matter here, and I’m not willing to think that much. (Nor am I likely capable of it at this point – and that’s assuming I’m not completely blowing the problem. I’m sure Drew will inform me if I am.)
I really have no idea what the answer should be to question number 1. I’m tempted to say that if the new CFO thinks he should get a bonus perhaps the company should sue the estate of the dead CFO for not doing his job properly.
As for question number 4 that depends: Is he getting any leg at the time of the deal? If he is, he can either add more legs, or upgrade the legs he’s got.
In what sense are the deductions mentioned not “goodie givingâ€, or, more simply, what should businesses get any tax breaks at all?
For interest on debt? If you think of capital as just another resource/expense, why not? As Drew mentions, labor and production inputs already get discounted, so why not capital costs?
I’m also wondering about the old CFO’s position. Why take on that small an amount of debt? They could pay that off in short order and keep a cash reserve from the profits. Shareholders’ equity increases and you’ve got one less set of ‘partners’ to worry about. Did he do that just to justify his position?
” And there are no risk free loans.”
I agree, but our banks from 2001-2007 thought that there were. So to answer Steve V’s question, I was referring to our recent context. When lenders think there is no risk, they are much too willing to loan. Borrowers who believe the same thing, especially if they are offered lower rates because of the bankers’ beliefs, are too willing too borrow.
Drew- Hope you are serious about teaching in your semi-retirement. Should probably limit it to graduate level, though I suspect a high end upper level undergrad course would be good also.
Steve
@sam, I would love to see someone go through a list of the G.E. tax benefits to see how many of them relate to policy goals that a majority of Americans would support. I’m not cynical enough to believe that corporations are simply getting benefits for their own interest as opposed to being knowledgeable and engaged enough to promote policies that are in the public interest for which they receive a private benefit.
I’m more in favor of significantly lowering the corporate tax rate and reducing all related tax deductions, credits, and exemptions, except perhaps an exemption for the first five years of a new business.
PD
As I said, I investigated Mr. Salam. I think he is well intentioned. However, his “subsidy of debt” argument and start up jobs is just boneheaded and flat damned wrong. Further, there is no debt subsidy, there is an equity penalty. But it is of course the nature of government and politics to obfuscate. But the economics don’t change.
Well, PD, I am that cynical. I’ve already said here that I’m in favor of eliminating corporate and personal income taxes in favor of a consumption tax with safeguards so that folks below certain income level are not unduly burdened. Folks toward the lower end of the income distribution spend 100% of what they make just to live. I think they should be cut some slack, perhaps by not taxing food, clothing, shelter, and maybe out-of-pocket health care expenses — or some other protective scheme.
sam
Are you suggesting that it is a “subsidy” that corporate entities are not taxed on revenue, before deduction of all input expenses, which var wildly depending upon the entity?
You really need to think long and hard about the implications of that. You really do.
“Are you suggesting that it is a “subsidy†that corporate entities are not taxed on revenue, before deduction of all input expenses, which var wildly depending upon the entity?”
I was asking for someone to argue, convincingly, that such things are not subsidies.
BTW, does this not imply that they are subsidies?
“This could all be fixed. Take all the tax crap out of it. Eliminate all the complexities of corporate finance and eliminate the corporate income tax, and let tax incidence fall where it may.”
What does ‘fix’ mean here if not correct something that is broken? And what is broken, in my view, is a system that subsidizes business via the tax code. What does ‘let tax incidence fall where it may’ mean if not, among other things, bye bye deductions?
ice
I assumed the drama I put in the story would signal that it was a sucker punch.
Here are the answers:
1) He should get no bonus. The value of the firm does not change. Its still worth $1.2 billion. You can’t juggle securities and change the value the value of the firm. Its still 8x earnings. There is a certain high profile B-School on the east caost that will remain un-named (Harvard) that had to be taught this lesson. Its now understood everywhere. However, on the mirror side, the cap structure……
2) A superior equity return? Perhaps. If company performance remained static, yes. However the RISK ADJUSTED RETURN would reflect the increase in financial leverage and associated risk. Its a fair deal in an arm’s length market. As always: risk and return.
3) Taxes. This should be obvious. Its what steve was attempting to get at but made the same mistake as both Dave and Salam made: there is a tax subsidized class of capital in debt. But is has absolutely nothing to do with job creation and start ups. BTW – take the investor side of the equation and noodle this for awhile. Interest income and ord div income is taxed at OI, unless you are the Harvard Endowment, and are tax exempt. But if you take your equity gains as cap gains you used to get taxed at 15%, but now at 23% with the change in the law plus Obamacare. Bad policy, but a fact. Unless you are the Berkeley Endowment. Anyone tired of messing with the tax code……….not the politicians.
4) Any leg to be had? Sadly, it turns out the secretary got around. But she got religion, and became a nun. Turns out the entire senior managment team quit after that and the company went bankrupt. So who cares about the damned taxes?
Here Drew is stating one of the fundamental principles of finance. The ratio of debt to equity does not affect the value of a company. Another way of stating it is that the value of a company is independent of how the company is financed.
Re:2 I ran some simple numbers and came out with a slightly lower return. (Assumed 120M at 5%, 180M at 7% 9% & 10%, assumed ten year bonds for all.) I got slightly lower returns on share prices. (I assume share prices had to drop in proportion to debt acquired – a very simple-minded assumption, I grant.)
So what did I goof up? I even get a lower return with all bonds at 5%. What did I miss?
I don’t know, if I’m a shareholder I might not mind this scenario. Sure, the value of the equity goes down but I get some immediate return. I think of it as insurance against an uncertain future. Of course I could get the same result by selling 45% of my shares, and suddenly I am remembering an example from long ago that covers this exact scenario.
Sure, NOW I remember. I bet that was in a chapter from Brealy/Myers book….
steve
“I agree, but our banks from 2001-2007 thought that there were.”
No they didn’t. In the early days they knew the loans that the feds demanded they make were uncreditworthy. So they sold them off their balance sheets. In fact, they pleaded with regulators for a way to get rid of them. And once that happened……well, loan originators did what loan originators do: use someone elses balance sheet. Thank you Barney Frank and Chris Dodd.
“When lenders think there is no risk, they are much too willing to loan. Borrowers who believe the same thing, especially if they are offered lower rates because of the bankers’ beliefs, are too willing too borrow.”
Any banker having gone through a basic credit training program doesn’t believe what you say. They do, however, respond (heh) to incentives. And the feds were social engineering, and demanding everyone be offered the “opportunity of home ownership,” loan to value and prior record of paying be damned.
Modigliani & Miller Proposition I: Firm value is determined on the left-hand side of the balance sheet by real assets – not by the proportions of debt and equity securities issued by the firm.
The example I suddenly remember is on pages 477-480 of Brealey/Myers Principles of Corporate Finance Sixth Edition.
Still, I’ve got to think capital structure matters, even absent tax considerations: It determines how the risks and rewards are divvied up. Selling 45% of my shares might be equivalent from a financial standpoint to having the company quintuple its debt load, but I’m also giving up 45% of my voting rights in the company. Which I guess begs the question: How easy is it to get a loan with common stock as the collateral? (Not a problem I’ve ever had or am ever likely to have.)
“I’ve already said here that I’m in favor of eliminating corporate and personal income taxes in favor of a consumption tax with safeguards so that folks below certain income level are not unduly burdened. Folks toward the lower end of the income distribution spend 100% of what they make just to live. I think they should be cut some slack, perhaps by not taxing food, clothing, shelter, and maybe out-of-pocket health care expenses — or some other protective scheme.”
Can you tell us how you see this working as a practical matter? Can you imagine, with all the products out there, how you would decide what products are VAT’ed and what not? Can you imagine the incentives for favoritism. Chile’s no VAT. Morton Steakhouse VAT’ed??
@Icepick, I don’t think its difficult at all to get a loan with common stock as the collateral (unless there are some restrictions on the stock), its just that if the stock price plummets, the loan agreement will likely have a clause that requires additional collateral or at least a partial pay down. This can be a big issue for small business in an economic downturn.
sam
There is no reason to be obtuse. You can’t make widgets without labor, RM, energy, capital. The cost of capital is just another input. I was sloppy in my wording. Debt is NOT being subsidized, unless you want to tax gross revenue. Equity is being penalized.
Can you tell us how you see this working as a practical matter? Can you imagine, with all the products out there, how you would decide what products are VAT’ed and what not? Can you imagine the incentives for favoritism. Chile’s no VAT. Morton Steakhouse VAT’ed??
Isn’t this what the FAIR Tax with its “prebate” is supposed to handle?
“Can you tell us how you see this working as a practical matter? Can you imagine, with all the products out there, how you would decide what products are VAT’ed and what not?”
Some states already do this for purposes of the sales tax.
“You can’t make widgets without labor, RM, energy, capital. The cost of capital is just another input.”
And I’m asking for a defense of allowing those costs to be deducted.
@sam, I am persuadable on the issues, but I do recall towards the end of last election cycle when the losing candidate was proposing dropping marginal rates and reducing deductions that the NY Times and other papers suddenly starting writing about how reducing tax expenditures would hurt many privately-provided social services. Since there are many good privately-run (though probably government subsidized) charities in my community, I don’t doubt it. When is a deduction a “tax loophole,” and when is it the simplest way for Congress to promote a public good when its unable to tax and spend for it?
Dave and then Ice correctly identify M&M. No, not the rapper.
It seems almost quaint now that such an obvious issue upon reflection took the great M&M tandem to force into common understanding. Perhaps the separation of the firm and capitalization (investors) isn’t as obvious to those not in the finance world as we now view it.
Just to put a bow around it because of ice’s – understandably – reflexive response that cap structure must matter. Forget the firm. Just forget it. It buys inputs and makes widgets that produces such and such cash flow. Period. Now think no further about the value of that. Its over.
Now turn 180 degrees in your chair and think about it from a capital providers perspective. Senior secured lender all the way down to common equity. What are the claims on that cash flow? The rights, the risks, tax treatment, the nuances of governance in case things don’t go well. All those loans and securities have different risk reward profiles and therefore different valuations to investors. THAT’s what changes when the cap structure. Not the value of the enterprise.
I hope this has been helpful. If you all get it now, Gene Fama would be proud. You are ahead of 85%+ of the population, ahead of 95% of the politicians of the world, ahead of our current president, and ahead of 99.9% of the Ivy League corporate finance faculty………and Paul Krugman. Sorry, couldn’t resist those last two.
“And I’m asking for a defense of allowing those costs to be deducted.”
sam, I’ve tried to be diplomatic here, but you are showing yourself to be a fool.
Let’s posit, since its a tax on revenue, of 10%. Some businesses make 20% profit margins. Some make 10%. Some make 5%.
You just put the last two in the 50% and 100% tax rate (on income) category. And out of business. Keep juggling the tax rate (lower), but then the view will be that high profit businesses are undertaxed. The natural response will be to change to a tax on income scheme. Oh, wait, that’s what we have.
I don’t know what you do or did, but a business and finance mind you do not have.
@PD
‘When is a deduction a “tax loophole,†and when is it the simplest way for Congress to promote a public good when its unable to tax and spend for it?’
But for there to be a deduction, there must be something to deduct against, no? It’s not a priori, to me anyway, that absent the income tax and the charitable deduction, privately-provided social services would go begging. I’m cynical, as I said, but not that cynical.
“THAT’s what changes when the cap structure CHANGES. Not the value of the enterprise.”
Sorry.
“Which I guess begs the question: How easy is it to get a loan with common stock as the collateral?”
ice – This is now getting too “inside baseball,” but secured lenders almost always take a security interest in the stock as well as the hard assets so that they have the a) option to exercise a sale of the enterprise as well as a piecemeal liquidation of hard assets and b) are unencumbered in a sale of assets.
But of course, our illustrious president upset all this at GM. What’s decades and decades of settled law when you have union votes to get, and capital to screw?? What, me worry?
@Drew/Icepick, regarding borrowing on common stock, I thought Icepick was talking about _individuals_ borrowing, either a CEO borrowing on stock to buy a vacation home or a small business owner borrowing on his retirement nest egg to expand his business. Looking back, I don’t think this is what Icepick was asking about.
@sam, I believe a millionaire testified in Congress last month that if charitable deductions were capped, he and others like him would reduce their charitable giving. Not eliminate, but reduce. It would have effects on the margins. I would still support capping deductions with the idea, over time, eliminating them.
Having a mistaken belief is not the same thing as an incentive. An incentive creates systematic behavior irrespective of market conditions. Having a mistaken belief on t he other hand does not work this way. Market conditions can change and show one the error of one’s beliefs.
You know, Drew, the honest answer, or at least the answer reflecting some understanding of the question I asked would be, “None of those deductions are justified save for the existence of the corporate income tax. They only exist, and can only be justified, because of that tax. Remove the tax, there is no longer any justification.”
@PD
“I believe a millionaire testified in Congress last month that if charitable deductions were capped, he and others like him would reduce their charitable giving.”
Perhaps, perhaps not. I tend more to the not side. Look at what the Koch brothers do. As much as they are reviled by a lot of folks, they do tremendous amounts of good with their charitable giving. See, Koch family foundations. I don’t believe for a second they do this because of the tax breaks. Some might cut back their giving, most wouldn’t I think. As I said, I’m cynical, but not that cynical.
PD, I meant individuals, but the question can be applied more broadly.
You are floundering now, sam. In over your head.
Oh stop it. Watching you in these kinds of arguments is amusing. Here’s your argument, boiled down and transposed to the field of transportation safety.
Concerned citizen: We need a speed limit on this road. It’s dangerous.
Drew: Lemme tell you how my Porsche works.