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Business News/ Opinion / The curious case of interest expense being tax deductible
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The curious case of interest expense being tax deductible

By changing the taxation treatment and eliminating bias towards debt, we can attract large capital

Shyamal Banerjee/MintPremium
Shyamal Banerjee/Mint

Raghuram Rajan, in a recent speech, mentioned how the overhang of debt is causing low economic growth rates after the Great Recession. Jens Weidmann, president of Deutsche Bundesbank, highlights a quirk in the taxation policy across the world which favours one form of capital: debt as against another form of capital—equity. “This runs counter to the fundamental principle of like taxation of like economic quantities," said Weidmann.

The theory of corporate finance has a famous theorem proposed by Modigliani-Miller, which states that the value of a firm is independent of its capital structure in a no-tax world. When an entrepreneur decides to invest money in a venture, it should be based on the economic return she expects irrespective of the capital structure the firm has. Since one form of capital—debt—is given a tax break whereas the other—equity—is not, there is a huge incentive for the entrepreneur to borrow and leverage her balance sheet to improve her returns on equity.

For the purpose of argument, let us assume the equity holder and the debt holder need the same return on their investment, which is 12%. Now, say, a business needs 100. If it borrows this money, the pre-tax cost is 12. But since this is a tax deductible expense, the actual cost is 8 (assuming 33% is the tax rate). The difference of 4 is the ‘tax subsidy on interest’ which the borrower receives from the government (assuming the business is a profitable one).

Now let us assume she raises 100 as equity. Since the investor needs a return of 12% in her hands, we need to consider two levels of taxation—income tax and dividend distribution tax. So, for an investor to get 12, it needs to be 21.6 in the books of the company. The reason being that on 21.6, income tax (at 33%) is payable, which reduces it to 14.45 and then to pay this to the investor, dividend tax of 17% needs to be paid, which further reduces the amount to 12.

As one can see, the business needs to generate merely 8 per 100 in case it borrows but needs to generate 21.6 per 100 if it raises equity. The government becomes one-third a partner in your business if you borrow as it shares the cost of capital, but dilutes your capital by one-third if you raise money through equity.

This ‘tax subsidy on interest’ is quite a large amount. If one looks at the total bank advances of 67 trillion, and assumes an average interest cost of 12% on that, the amount is close to 8 trillion. And a tax subsidy of 22.4% (as per FY13 budget documents) on that amount is nearly 1.8 trillion or close to 1.6% of the gross domestic product (GDP).

This subsidy has increased over the past few years as the average tax rate of companies had gone up from 19.4% (FY04, as per budget documents) to 22.4% (FY13) and the dividend distribution tax has gone up from nil to 17% (1997-2014). These rate increases have made debt capital far cheaper than equity capital. No wonder then that the Indian corporate sector today is heavily leveraged.

How does it matter that equity capital is expensive because of tax reasons? Equity capital is the buffer which can absorb shocks. An equity holder is prepared to take losses in return for sharing the upside. A debt holder, on the other hand, needs to feel secure. And the best security she can get is when the company is adequately capitalized. In India, banks are the primary source of debt capital, therefore, it is imperative that they do not end up bearing losses due to inadequate equity. This will impair their ability to service their depositors resulting in a financial maelstrom.

Also, in the absence of adequate equity, debt takes on the role of surrogate equity and becomes as expensive as equity. Rajan, too, highlighted this aspect of cost of debt being high because of low creditworthiness of companies.

How can this differential taxation be remedied? One way in which it can be remedied is to stop making interest expense tax deductible. Simultaneously, the corporate tax rate can be lowered to the extent of the gains of higher tax revenues due to elimination of the ‘interest subsidy’. Secondly, instead of dividend distribution tax, earnings from equity should be taxed in the hands of the equity investor just as it is in case of a lender. Given that these are significant changes in the tax law, a long enough transition period can be given to companies to do the necessary changes in their capital structure.

It is indeed a unique time in the global economic history when investors are willing to lose capital by investing in government bonds of strong economies. At such a time, India can attract a huge amount of capital. But if this capital comes in the form of debt, it would make the economic recovery unsustainable. Instead, by changing the taxation treatment and eliminating the bias towards debt, we can attract large sums of capital which, in turn, will help fund innovation and infrastructural projects, thereby ensuring a sustainable economic growth. Domestic savers will also find equity more attractive, which will help create wealth for Indian households.

Huzaifa Husain is head-equities, PineBridge Investments, India.

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Published: 16 Feb 2015, 06:11 PM IST
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