QUESTIONS:
Would abolishing corporate profit taxes reduce corporate debt, and hence reduce corporate bankruptcy risks and reduce the balance sheets of fractional reserve banks? Would even an equal tax treatment of interest rates and dividends have the same effect? Have corporate taxes and the growth of the FED system gone hand in hand historically?
DESCRIPTION:
Companies can finance themselves with debt or equity. Debt has great tax advantages, because the cash flow to lenders (interest payments) are tax deductable lika any operating cost, while cash flow to equity holders is taxed like profit. By increasing debt, a company reduces its tax costs. At the same time it increases the relative return to equity holders.
The drawback is of course that the interests of the debt, in contrast to dividends to equity, must be paid on certain dates even if the company makes a loss. That obligation creates a risk for bankruptcy, and hence an expected bankruptcy cost. (Bankruptcy is basically just a change of ownership to the company, but the process normally brings with it reduced production, flight of qualified staff, disorganized operations, loss of clients, worse conditions from suppliers and other such genuine costs to both new and old owners, those are “bankruptcy costs”). So basically, a company should increase its debts until the reduction in tax costs equals the increase in expected bankruptcy costs. Therefor, the existence of a corporate tax causes a higher rate of bankruptcy among corporations.
Let’s illustrate this with some numbers. Assume a new company which will buy assets worth 100. It considers to finance its assets either with 10 debt and 90 equity, or with 90 debt and 10 equity. It expects to make 10% return on assets. Interest rate is 5%. Corporate tax rate is 25%.
The 10 debt + 90 equity alternative:
+10 operational profit
-0.5 interest rate payments (105%)
=9.5 profit after financial expenses
-2.4 tax on profit (9.525%)
=7.1 net profit after tax
7.9% return on equity (7.1 / 90, since equity is 90)
The 90 debt + 10 equity alternative:
+10 operational profit
-4.5 interest rate payments (905%)
=5.5 profit after financial expenses
-1.4 tax on profit (5.525%)
=4.1net profit after tax
41.3% return on equity (4.1 / 10, since equity is 10)
Of course, the net profit of the company is reduced from 7.1 to 4.1. But since you as equity holder have freed up 80 (90-10) to be invested in other companies, your return on equity from this company increases drastically from 7.9% to 41% simply by increasing the debt. Also note how relatively small the tax payments, 1.4 or 2.4, is to the difference in the amount of debt created, which is 80 (although my input numbers are of course arbitrary).
If interest rates payments were taxed the same way as dividends to equity are, then the return on equity would’ve been 30% instead of 41%:
10 operational profit
-2,5 profit tax (1025%)
=7,5 net profit after tax
-4,5 interest rate payments (905%)
=3,0 net profit to equity holders
30,0% return on equity (3 / 10, since equity is 10)
Both with and without interest rates being taxed the same way as are dividends, companies can have good reasons to leverage themselves with debt. But the corporate profit tax “discrimination” to the benefit of interest rate payments to debt before dividend payment to equity, gives a great incentive to companies to increase their debt leverage further.
I want to know if anything is fundamentally wrong with the description of the connection between corporate tax and debt. If it is roughly correct, then why is it so quiet about it? Especially from Austrian economists. Abolishing the FED would be super nice, yes. But abolishing corporate taxes (or at least the excemption of interest rates from profit taxation) might also be a relatively efficient measure in order to reduce fractional reserve banking in the mean time. Even Democrats should love the idea of applying profit tax on interest rate payments! And I think that such a tax increase would actually be a welcome step towards increased free market economy and reduced FED and FRB power! Especially these days, the bankruptcy costs caused by corporate debt, which where taken only to reduce corporate tax payments, reveals how very destructive the current corporate tax is.