Tax distortions are likely to have encouraged excessive leveraging and other financial market problems evident in the crisis. These effects have been little explored, but are potentially macro-relevant. Taxation can result, for example, in a net subsidy to borrowing of hundreds of basis points, raising debt-equity ratios and vulnerabilities from capital inflows. This paper reviews key channels by which tax distortions can significantly affect financial markets, drawing implications for tax design once the crisis has passed.
Staff Discussion Notes showcase the latest policy-related analysis and research being developed by individual IMF staff and are published to elicit comment and to further debate. These papers are generally brief and written in nontechnical language, and so are aimed at a broad audience interested in economic policy issues. This Web-only series replaced Staff Position Notes in January 2011.
The tax deductibility of interest payments in most corporate income tax systems coupled with no such measure for equity financing creates economic distortions and exacerbates leverage. This paper discusses the consequences of this debt bias and the possible remedies.
Risks to macroeconomic stability posed by excessive private leverage are significantly amplified by tax distortions. ‘Debt bias’ (tax provisions favoring finance by debt rather than equity) has increased leverage in both the household and corporate sectors, and is now widely recognized as a significant macroeconomic concern. This paper presents new evidence of the extent of debt bias, including estimates for banks and non-bank financial institutions both before and after the global financial crisis. It presents policy options to alleviate debt bias, and assesses their effectiveness. The paper finds that thin capitalization rules restricting interest deductibility have only partially been able to address debt bias, but that an allowance for corporate equity has generally proved effective. The paper concludes that debt bias should feature prominently in countries’ tax reform plans in the coming years.
Tax provisions favoring corporate debt over equity finance (“debt bias”) are widely recognized as a risk to financial stability. This paper explores whether and how thin-capitalization rules, which restrict interest deductibility beyond a certain amount, affect corporate debt ratios and mitigate financial stability risk. We find that rules targeted at related party borrowing (the majority of today’s rules) have no significant impact on debt bias—which relates to third-party borrowing. Also, these rules have no effect on broader indicators of firm financial distress. Rules applying to all debt, in contrast, turn out to be effective: the presence of such a rule reduces the debt-asset ratio in an average company by 5 percentage points; and they reduce the probability for a firm to be in financial distress by 5 percent. Debt ratios are found to be more responsive to thin capitalization rules in industries characterized by a high share of tangible assets.
The economic crisis following the COVID-19 pandemic has increased the debt levels of corporations and reduced the level of investments. From a tax perspective, interest payments on debt are generally deductible from the corporate tax base, while costs related to equity are not. This debt-equity bias is a deep-rooted issue in today's tax system and inhibits equity-financed investments. From a microeconomic perspective, the bias leads to socially undesirable inefficiencies in capital markets, resulting in welfare losses. From a macroeconomic point of view, high debt levels hinder economic growth. To provide a stable and supportive tax environment for a sustainable recovery after the corona crisis, the European Commission has published a framework on "Business Taxation for the 21st Century" in May 2021. Besides other (long-term) proposals, a debt equity bias reduction allowance (DEBRA) should be developed to address the tax-induced distortions of debt financing. For a legislative proposal, the European Commission identified three possible concepts: First, a Comprehensive Business Income Tax (CBIT) that disallows the tax-deductibility of any financing cost. Second, an Allowance for Corporate Equity (ACE) that provides for the deductibility of notional interest on either all equity or new equity. And third, an alignment of the treatment of debt and equity financing by deducting a notional return on all capital, namely an Allowance for Corporate Capital (ACC).
Most tax systems create a tax bias toward debt finance. Such debt bias increases leverage and may negatively affect financial stability. This paper models and estimates debt bias in the financial sector, and present novel estimates for investment banks and non-bank financial intermediaries such as finance and insurance companies. We find debt bias to be pervasive, explaining as much as 10 percent of total leverage for regular banks and 20 percent for investment banks, with the effects most pronounced before the global financial crisis. Going forward, debt bias is likely to once again gain prominence as a key driver of leverage decisions, underscoring the importance of policy reform at this juncture.
Although the empirical literature has long struggled to identify the impact of taxes on corporate financial structure, a recent boom in studies offers ample support for the debt bias of taxation. Yet, studies differ considerably in effect size and reveal an equally large variety in methodologies and specifications. This paper sheds light on this variation and assesses the systematic impact on the size of the effects. We find that, typically, a one percentage point higher tax rate increases the debt-asset ratio by between 0.17 and 0.28. Responses are increasing over time, which suggests that debt bias distortions have become more important.
This paper investigates the role of tax incentives towards debt finance in the buildup of leverage in the nonfinancial corporate (NFC) sector, using a large firm-level dataset. We find that so-called debt bias is a significant driver of leverage, for both small and medium-sized enterprises and larger firms, with its effect accounting for about a quarter of leverage. The strength of this effect differs with firm size, the availability of collateral, income and income volatility, cash flow, and capital intensity. We conclude that leveling the playing field between debt and equity finance through tax policy reform would decrease NFC leverage, reducing economic risks posited by leverage.
The countercyclical capital buffer (CCB) was proposed by the Basel committee to increase the resilience of the banking sector to negative shocks. The interactions between banking sector losses and the real economy highlight the importance of building a capital buffer in periods when systemic risks are rising. Basel III introduces a framework for a time-varying capital buffer on top of the minimum capital requirement and another time-invariant buffer (the conservation buffer). The CCB aims to make banks more resilient against imbalances in credit markets and thereby enhance medium-term prospects of the economy—in good times when system-wide risks are growing, the regulators could impose the CCB which would help the banks to withstand losses in bad times.
