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Opinion | Let us rethink limited liability and tax deductions on interest
It is time to stop privileging debt over equity and thus short-term growth over long-term growth
In June, the amount of junk bonds—below-investment grade—issued in the United States was the best monthly sale of such bonds ever. The amount sold was $46.7 billion and it bettered the earlier record of $46.4 billion set in September 2013. Year-to-date volume of junk bonds sold up to 24 June in 2020 was $199 billion, about 66.5% more than a year ago (Junk Bonds Topple Monthly Sales Record in ‘Party Like No Other’, Bloomberg, 24 June). At the same time, the amount of default in leveraged loans (those extended to already highly indebted entities) totalled $36.9 billion up to mid-June, including a record $14.6 billion in May, the highest in a month since April 2014 (US loan issuance plummets in 2Q as market takes stock of new normal, Reuters, 1 July).
That the record amounts of debt raised by all entities—the sovereign, private sector and households—has done precious little to boost real economic growth, productive investment, productivity and employment is, by now, well documented. Exhibit A is Japan. The UK and United States are not far behind. The proportion of zombie companies—those whose earnings are barely adequate to service debt—has risen to one-fifth of all U.S. firms from nearly zero in 1990. Not coincidentally, these three decades have featured increasingly radical monetary policy experiments. What needs to change?
Top of the list is the monetary policy framework. However, monetary policy is beyond the pale now. It will meet with its eventual comeuppance and will be consigned to the dustbins of history, heaped with scorn and condemnation. The other policy is the deductibility of interest payments from taxable income. It not only encourages debt but also erodes the tax base. At a time when current and future demands on the government to support the weaker sections of society are rising, the deductibility of interest from taxable income deserves a serious reconsideration. This deductibility was first permitted for banks in Britain since borrowing was a business necessity for an institution whose business is leverage on both sides of the balance sheet. Soon, it spread to non-financial entities. That is how it got entrenched. Then, it got extended to mortgage interest payments. There is no obvious logic to this deductibility.
Second, interest payments are higher up in the pecking order than obligations to the state and society. That is, the creditor comes before the sovereign. Should that pecking order be re-thought? Should profit be calculated before interest payments and the tax liability determined on that, and then the residual be used to pay the sources of capital—both interest and dividend? Then, there would be true indifference to equity and debt. Right now, debt is the favoured child. It would also increase the tax base at a time of rising public debts.
This change would also be consistent with the idea that the pandemic is a consequence, among other things, of an attitude of favouring economic growth at all costs. Debt compounds this attitude. Debt not only favours growth at the expense of stability but also short-term growth over long-term because debt brings forward future growth. Beyond a certain level of debt, there is nothing left to borrow from the future and only the mirage of growth remains. Many countries, including China, have reached that level. So, treating interest and dividend payments equally and relegating them lower down the pecking order in terms of corporate obligations would be a good lesson to learn from the pandemic. Preference for debt will drop, speculative asset bubbles will either form slower or not form at all, and businesses will rely on real rather than financial engineering to grow.
Professors Charles Goodhart and Rosa Lastra argue, in a paper Equity Finance: matching liability to power published in February 2019, that one more innovation of the 19th century encourages debt-financing and that is the concept of limited liability. Equity holders enjoy the upside of debt but not the downside, which is limited to the amount of their investment. Of course, limited liability was the engine of capitalism and, according to the two professors, in 1926, the Economist put the inventor of limited liability on par with Watt and Stephenson, the other pioneers of the Industrial Revolution. Limited liability encouraged the mobilisation of capital and hence the creation of scale. Without scale, industrialisation could not have happened and capitalism would have been stillborn. Now, the two professors recommend unlimited liability for insiders and limited liability for outside shareholders. Of course, they recognise the difficulties in the switchover to unlimited liability and propose pilot attempts with financial institutions and mitigating measures.
Developed countries should be pursuing equity and stability relative to growth. Developing countries should be pursuing sustainable growth if they were not to meet with the same fate of indebtedness and the prospect of repudiation of debt and repudiation of promises to senior citizens as the only means of salvaging national budgets. Hence, rethinking tax deductibility of interest and the concept of limited liability are global imperatives. Avoiding another pandemic may depend on this.
V. Anantha Nageswaran & Gulzar Natarajan are, respectively, a member of the Economic Advisory Council to the Prime Minister, and an Indian Administrative Service officer. These are the authors’ personal views.
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First Published:6 Jul 2020, 08:42 PM IST
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