Monday, January 23, 2012

What the Bain Gang Can Teach Us about Corporate Tax Reform

We need to kill the business interest deduction.

As we noted in our discussion about eliminating the mortgage interest deduction, interest has historically been tax deductible. In fact, it wasn't until 1986 that personal interest was not deductible -- thank you, astonishing growth in credit cards and personal debt -- though the mortgage interest deduction was preserved. 

But it's now time to think about whether business interest should be deductible at all, and one of the best arguments against it is courtesy of private equity concerns like Bain Capital.

First, though, how awesome is that picture.

Private equity is a bit of a catch-all term that includes things like venture capital (to get a company off the ground and running), mezzanine capital (providing additional capital to an existing company), and leverage buy-outs (see Gordon Gekko). 

When Romney has been talking about creating jobs, he's been talking about venture capital. When people talk about the companies killed by Bain Capital, they're talking about leveraged buy-outs.

In its simplest form, a leverage buy-out is a like a mortgage, where you use the asset you want to buy to secure the financing necessary to make the purchase. Josh Kosman explains to Mike Konzal:
JK: The whole industry started in the mid-to-late 1970s. The original leveraged buyout firms saw that there were no laws against companies taking out loans to finance their own sales, like a mortgage. So when a private equity firms buys a company and puts 20 percent down, and the company puts down 80 percent, the company is responsible for repaying that.
Now the tax angle is that the company can take the interest it pays on its loans off of taxes. That reduces the tax rate of companies after they are acquired in LBOs by about half. Banks, also realizing this tax effect, were willing to finance these deals. At the time, you could also depreciate the assets of the company you were buying — that’s not true today.
They saw that you could buy a company through a leveraged buyout and radically reduce its tax rate. The company then could use those savings to pay off the increase in its debt loads. For every dollar that the company paid off in debt, your equity value rises by that same dollar, as long as the value of the company remains the same.
MK: So the business model is based on a capital structure and tax arbitrage?
JK: Yes. It’s a transfer of wealth as well. It’s taking the wealth of the company and transferring it to the private equity firm, as long as it can pay down its debt.  It think it is real - the very early firms targeted industries in predictable industries with reliable cash flows in which they by and large could handle this debt. As more went into this industry, it became very hard to speak to the original model. Now firms are taken over in very volatile industries. And they are taking on debts where they have to pay 15 times their cash flow over seven years — they are way over-levered.
MK: The most common argument for why Bain Capital and other private equity firms benefit the economy is that they are pursuing profits. They aren’t in the business of directly “creating jobs” or “benefitting society,” but those effects occur indirectly through the firms making as much money as they can.
But even here, “profits” — how they exist, where they come from, and how they are timed — have a crucial legal and regulatory function. A recent paper from the University of Chicago looking at private equity found that “a reasonable estimate of the value of lower taxes due to increased leverage for the 1980s might be 10 to 20 percent of firm value,” which is value that comes from taxpayers to private equity as a result of the tax code. Can you talk more about this?
JK: That sounds about right. If you took away this deduction, you’d still have takeovers, but you’d have a lot less leverage and the buyer would be forced to really improve the company in order to make profits. I think that would be a great thing.
If you look at the dividends stuff that private equity firms do, and Bain is one of the worst offenders, if you increase the short-term earnings of a company you then use those new earnings to borrow more money. That money goes right back to the private equity firm in dividends, making it quite a quick profit. More importantly, most companies can’t handle that debt load twice. Just as they are in a position to reduce debt, they are getting hit with maximum leverage again. It’s very hard for companies to take that hit twice. 
So leveraged buy-outs aren't about turnaround artists, people who take failing companies, re-organize  them and get them back on track. Instead, it's financial engineering, just taking advantage of the tax code. As James Surowiecki at the New Yorker notes,

The rewards can be extraordinary: when Romney was at Bain, it supposedly earned eighty-eight per cent a year for its investors. But piles of debt also increase the risk that companies will go bust.
[B]etween 2003 and 2007 private-equity funds took more than seventy billion dollars out of their companies. These dividends created no economic value—they just redistributed money from the company to the private-equity investors.
And the business interest deduction is exploited by other industries as well, most notably investment banking. When a bank raises money by selling more equity, it faces a couple of problems. The first is that the previous group of shareholders are generally not happy, as the percentage of their ownership of the bank has gone down. Secondly, when the bank pays dividends, those dividends are not tax deductible, which makes the company less profitable. 

Raising capital by issuing debt solves both those problems. Each shareholder's stake remains the same, and the disbursements to the bond holders get written off the taxes. This led to some of the banks, most notably Lehman Brothers, becoming grossly over-leveraged, by some estimates up to 44:1. This made Lehman Brothers a very profitable company when times were good, but almost insured that it would get pummeled in the (inevitable) event of an economic downturn.

But what does the leverage really mean? Let's walk though an example, using a somewhat higher leverage ratio of 50:1. 

At that ratio, you could put up $2 but would have $100 in purchasing power, with the remaining money being supplied by a bank. If you invested that in stock, and the stock's value went to $101, you'd have a return of 50% -- you initially put up $2, but now have $3. 

But leverage works the other way as well. If the value of the stock drops by 1% -- form $100 to $99 -- you've lost 50% of your equity. And if the stock drops another dollar, your finished. 

(For the sake of comparison, the Federal Reserve limits the leverage you can use to buy stock to 2:1 through Reg T. (although that ratio can increase to 3:1 once the purchase has settled. Still, not so bad.)

The business interest deduction certainly made sense some time ago, but the financial wizards have turned it into a real hazard. Getting rid of this tax break would't prevent leveraged buy-outs or raising capital through debt, but it would re-focus these efforts on making sure the companies themselves did well. Private equity firms, banks and other corporations would have more "skin in the game," and the tax disadvantage of raising capital through equity would disappear.

It's also worth remembering that, despite the crowing about corporate taxes, the percentage of pre-tax corporate income used to pay taxes has fallen dramatically over the last 50 years:

From Kevin Drum and the Federal Reserve of St. Louis.
And corporate tax as a percentage of all US tax revenue has fallen harder.

See page 68 of this 2010 Senate Committee on Finance report. And thank you,  Felix Salmon.
So if we're trying to get the deficit back under control, we should be looking seriously at making corporations pay their fair share as well. Eliminating the business interest deduction would be one step down that path. 

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