13/10/2013: On Taxes, Debt & Equity

EU Commission published some interesting research into Tax Reforms across the EU. The paper is available here: http://ec.europa.eu/economy_finance/publications/european_economy/2013/pdf/ee5_en.pdf

One interesting topic covered relates to the substitution away from equity in favour of debt funding in corporate capital investment. A chart to start with:

Now, per above, the disincentives to equity investment and incentives in favour of debt seem to be the lowest (in euro area) in Cyprus and Ireland. Note that these countries are associated with aggressive brass-plating (Luxembourg) are distinct from countries with aggressive tax arbitrage activities (Cyprus and Ireland). And thus, behold the skew in the EU Commission analysis: MNCs investing into these countries do not use debt on-shoring (US MNCs do not borrow in these countries), but use registry of equity there (for example, in Irish case - due to FDI-booked investments, or equity investment by IFSC companies, ditto for old Cypriot banking system vis Russian corporates).

The EU admits almost as much:
"There is also evidence that the tax advantage of debt fuels international profit-shifting activities as
rules on interest deductibility differ between countries and there are mismatches in decisions on which instruments are considered debt financing. Several studies analyse the debt financing of multinationals with either parent companies or subsidiaries in the United States, Germany, Canada and the EU. The results of these studies suggest that firms use intra-group loans to adapt their financial structure and minimise their overall tax burden. By shifting debt to an affiliate located in a high-tax country, corporate groups are able to deduct interest payments against a higher statutory tax rate while the interest received by the lending affiliate is taxed at a lower rate. Taking data from 32 European countries between 1994 and 2003, Huizinga et al. (2008) find that a 10 % increase in the tax rate increases leverage by 1.8 %. The authors also show evidence of debt-shifting as, for multinationals with two equal-size establishments in two countries, a 10 % increase in the tax rate in one country leads to an increase in leverage of the company located in that country by 2.4 % and a decrease in leverage in the affiliated foreign company by 0.6 %."

However, overall the tax rates also play the role in this debt-shifting: "Two recent meta-studies by Feld et al. (2013) and de Mooij (2011a) review the existing empirical studies and find that ... a one percentage point higher CIT rate is associated with a 0.27 percentage point higher debt-asset ratio."

Two more major points raised in the paper:

1. Welfare costs: "The tax bias towards debt financing also creates welfare costs. Weichenrieder and Klautke (2008) estimate this cost at between 0.08 % and 0.23 % of GDP, while Gordon (2010) estimates it at about 0.25 % of GDP. As pointed by de Mooij (2011b), these estimates ...fails to take into account the heterogeneity of responses and hence the additional welfare costs due to misallocations. Existing studies also fail to include the larger welfare costs of the negative externalities of using debt, such as systemic risk, the probability of default and the social costs of business cycle fluctuations. Finally, they do not take into account the distortions created by debtshifting activities and misallocation due to international tax arbitrage and administrative and compliance costs (de Mooij, 2011b). Consequently, the welfare impact of the debt bias can be assumed to be higher than what has been found in the literature so far."
2. Banking Systems and Debt Shifting: "Keen and de Mooij (2012) ...show that taxes influence the capital structure of banks and that, despite capital requirement constraints, the size of the effects of corporate taxation on the financial structure of banks is close to those for non-financial firms." In other words: capital rules do not induce any significant changes in banks behaviour when it comes to funding of banking activities: debt incentives still drive leverage up. Furthermore, "Hemmelgarn and Teichmann (2013) have found that bank leverage, dividend payouts and earnings management (in terms of loan loss reserves) react to changes in the domestic statutory CIT (corporate income tax) rate. ...In the three years after a tax increase by 10 percentage points, the results predict an increase in leverage of 0.98 percentage points or a relative increase by about 1.1 % (in relation to the equity ratio it would mean a notable relative decrease, of 8.9 % of equity)." Core conclusion: "These results suggest that a reduction in the preferential treatment of debt would result in a significant decrease in bank leverage. In addition, the results also show that regulatory capital requirements in the banking sector alone do not seem to be a prime determinant of financial structure. ... the effect of taxation conflicts with the aim of current regulatory reform to increase capital in the context of Basel III."

10/2/2013: EU Budget 'cut': neither reformist, nor significant enough

EU has agreed the next multi-annual framework for its budget. One of the best summaries I have read is here: http://www.bruegel.org/nc/blog/detail/article/1010-how-to-read-the-eu-budget-deal/#.URfavqFaZF8

The framework covers 2014-2020 period.

The reduction of the EU Budget from from 1.12% of GNI to 1% of GNI, in my opinion, is in line with the overall fiscal tightening across the EU and is a good thing (note, obviously my analysis will be different from that of Bruegel - linked above). The reason why I perceive this to be a strength of the Budget is that I generally do not perceive EU expenditure as being more economically efficient or necessary than that by the Member States. The further you detach spending from the sources of revenues (and the EU Budget is as far detached as feasible to imagine), the more weakly is the expenditure anchored to the needs of the economy.

Net reduction - as measured by the payments, is from EUR988bn to EUR908.5bn - is a relatively marginal 8.05%, not exactly an earth-shattering level of fiscal crunching. Furthermore, much of planned payments allocated in the past have gone unspent, implying that the effective 'cut' is most likely going to turn out much shallower than 8.05% headline figure.

Crucially, I disagree with the implicit Brugel position (based on their criticism of the Budget's 'pro-growth' momentum) that the EU expenditure should be considered in the light of economic growth enhancement or economic contraction. The EU Budget allocations can and do set dangerous precedents of creating permanent interest groups reliant on EU funding for jobs and demand generation. One of the best examples are EU research and development subsidies. Since the EU budget is drawn out of the national resources, any 'stimulus' the EU Budget can create is at the very best a reallocation of similar stimuli from national economies. Synergies at the pan-European or cross-European investment levels (e.g. building common integrated infrastructure etc) enhance the EU Budget growth-support capacity, but bureaucratic duplication, and interest groups politics reduce it in return. With much of EU Budget going to 'soft' programmes, where (1) substitution effects relative to nationally-administered programmes are unclear, and (2) transfers are subject to EU-level political and bureaucratic objectives and constraints, it is hard to imagine the EU expenditure to be more 'stimulative' than a national expenditure.

Furthermore, in the environment of continued debt consolidation and budgetary tightening policies at the national levels, it is hard to imagine that the EU spending priorities would see more efficient allocation of funds than tighter national priorities. In other words, one has to ask a simple question of whether funding another cross-border EU 'cohesion' project is the better use of increasingly scarce resources in the environment where both countries involved are cutting back hospitals and schools.

As Bruegel correctly points out, there are no reforms undertaken in the Budget. My concern here, however, is more on the expenditure side, while Bruegel concern is focused on revenue side. I simply do not see the EU Commission to currently have either democratic or fiscal capacity to begin collecting direct taxes of any variety. Proposed move of the Commission into indirect taxation (e.g. FTT etc) is likely to cement further the democratic deficit in the EU by providing EU Commission with all the trappings of sovereign power and requiring no direct accountability usually associated with direct taxation.