By: Leandra Lederman
On January 18, the Indiana University Maurer School of Law welcomed Prof. Tom Brennan from Harvard Law School as the first speaker of the year in our Tax Policy Colloquium. Tom presented an early draft of a paper co-authored with Robert L. McDonald, Debt and Equity Taxation: A Combined Economic and Legal Perspective. We had a lively and interesting discussion about it in the workshop, as well as over dinner.
The paper, which I do not believe is publicly available yet, deals with the taxation of hybrid securities. It describes current law on how those securities are categorized as debt or equity, as well as the history of how the law developed. The paper criticizes the binary categorization of hybrid instruments as either debt or equity. It thus argues for a bifurcated approach.
The core of the current draft is a proposed new approach to debt and equity that considers the capitalization of a corporation as a whole and taxes the components in line with the underlying economics. The paper disaggregates the risk-free return, the risky return, and abnormal returns (rents). The paper proposes two possible systems of taxation: the “unlevered equity system” and the “levered equity system.” In the unlevered equity system, debt consists of risk-free obligations (like short-term Treasury bills) and equity is unlevered ownership of assets. In the levered equity system, the definition of debt is the same but equity is fully leveraged ownership of assets (fully financed by risk-free obligations). Under the unlevered approach, although particular investors may own a mix of debt and equity, the corporation itself effectively issues no net debt because it issues no risk-free obligations.
A key insight of the paper applies the Domar-Musgrave economic result that, under certain assumptions, risky returns on assets do not bear tax. Brennan and McDonald point out that the Domar-Musgrave insight also applies to corporations, although the securities are liabilities for them instead of assets. (Many years ago, I applied Domar-Musgave analysis in an article of mine on the tax favoritism for entrepreneurship, but I had not thought about its possible application to corporate income, which is a fascinating idea.) The implication of that insight, as Brennan & McDonald note, is that the risk-premium portion of return on investment effectively does not bear tax. As a result, under the unlevered system, all corporate income would bear corporate tax because the unlevered system does not have any net debt obligations. By contrast, adopting the levered system would make the corporate tax burden only rents, given a tax deduction for debt. The paper explains that this reaches the same result as the Mirrlees Review’s exemption for “normal returns” on corporate capital, as well as the allowance for corporate equity (ACE), if the ACE deduction is defined in a particular way.
Under either the levered or unlevered systems, for the investor, the amount of debt is the dollar change in the value of the investor’s holdings for each dollar of change in the corporate assets (delta). Accordingly, the paper’s approach (whether the levered or unlevered system is used) would require continual updating of the debt and equity components of the corporation’s capitalization, which poses an administrability issue, as the paper acknowledges.
In part, Brennan & McDonald’s paper is driven by a concern about banks overleveraging themselves—beyond savings deposits—as a result of the favorable tax treatment traditionally afforded to debt. With a note that more is to come, the paper discusses total loss-absorbing capacity (TLAC) instruments that convert from debt to equity when the bank experiences economic distress. Tom also talked a bit more about this issue in the colloquium. It is interesting to think about whether treating TLACs as debt is the best approach to addressing systemic risk. Should there be a tax piece of this, or would the issue better be left to non-tax regulators?
The IU Maurer Law School’s Tax Policy Colloquium series will continue on February 1, with Prof. Jake Brooks from Georgetown Law School presenting The Case for Incrementalism in Tax Reform.