Debt versus equity ruminations

One of the two classes that I’m teaching this semester, Corporate and International Tax Policy (the other is Survey of U.S. International Taxation) occasionally prompts me to think in general terms about familiar topics. Last week the topic was debt versus equity in the corporate tax setting.  Preparing for the class led me to think about the following:

It’s either a sign of mental health or schizophrenia – I’m not sure which – if you can believe two inconsistent things at the same time. This is very true of the tax policy issues raised by debt and equity, or more generally by the variegated taxation of financial instruments. Each of the two competing lead stories has some truth. Yet they can’t simultaneously be true (except each and inconsistently in part). And the truer one story is, the less true the other one is.

Idea 1 holds that the tax bias between debt and equity – usually, though not always, involving a relative tax preference for debt – creates damaging economic problems when people pick the wrong instrument (as judged on a pre-tax basis) for tax reasons. For example, excessive use of debt might create undue systemic default risk.

Idea 2 says instead: C’mon, people can make whatever economic arrangements they like, and label them “debt” or “equity” as they like.  It just takes a bunch of lawyers writing 12-factor memos and concluding that, more likely than not, the taxpayer’s preferred characterization of a given arrangement would stand up if closely examined by the IRS.  So the real problem isn’t economic distortion, given the fact that people can dress up their arrangements with whatever they like – it’s electivity of tax treatment.  For example, tax-exempts use “debt,” thereby zeroing out the entity-level tax on their share of the business income. Meanwhile, taxables, if their marginal rate exceeds that at the entity level (which lowering the corporate rate would make far more common) use “equity” and avoid owner-level realization, thus electing into a lower tax rate environment.

Obviously, these two stories can’t both be entirely true at the same time – they contradict each other.

Relatedly, here are two different ways of viewing the universe of financial instruments:

Idea 1 holds that 2 fixed points, classic fixed return debt and classic common-shares equity, retain enormous importance in financial markets, thus creating the above-referenced Idea 1 distortions.

Idea 2 holds that financial instrument choice is an undifferentiated, multidimensional continuum.  For example, how fixed versus variable, on the upside and the downside, is the expected return? Options, default risk, payment variables, etcetera, can all result in slicing and dicing this pretty fine.  Likewise, classic differences between “debt” and “equity” such as enforceability for the former and voting power for the latter can perhaps be made to vary continuously in their actual economic significance.  With a multidimensional continuum in which investors can point whatever point they like, a one-dimensional “debt versus equity” continuum may be unlikely to affect them very much, other than in requiring that they pay lawyers (along with accountants and others) to fine-tune things, and accept perhaps a very slight risk of serious IRS challenge.

The two Idea 1’s reinforce each other, as do the two Idea 2’s. The analytical problem is that, while both sets of ideas appear to have some truth, each undermines the other. So even if we agree (as I do) that we have a debt-equity problem, it’s not entirely certain just how (as a matter of relative weighting for the two sets of competing concerns) we should think about the problem.