Tax havens have been the object of intense scrutiny in the 2000s. The focus has been on both the lax tax regimes of these jurisdictions as well as the often weak regulatory framework particularly in respect of hedge funds and various types of SPVs. Often, the centres are said to facilitate criminal activities, since some centres do not comply with the Financial Action Task Force (FATF) rules in respect of anti-money laundering regulations.
The crisis has coincided with a step-up in a generalized clampdown on undeclared offshore accounts, which had been building up over the previous decade. A number of very publicized episodes have involved the transfer to the tax authorities of the names of holders of offshore accounts. Individual finan-cial institutions have been held responsible for encouraging unlawful activity and faced significant fines. The authorities appear to have exploited the wave of anti-bank feeling to extend their extra-territorial powers and step up inter-national cooperation to push through further anti-evasion measures.
A different set of issues is raised by the exploitation of regulatory and tax arbitrage involving offshore centres. The use of offshore centres to create corporate or other types of vehicle is often driven by the absence of adequate onshore forms of intermediation, particularly for foreign investors. This may be due to delays in creating enabling legislation and uncertainty in respect of the nature of domestic legislation.
1.4 The tax policy and the macroeconomy
During the crisis the governments implemented several measures to avoid the collapse of thefinancial system and to alleviate the economic consequences of the crisis on the real economy. The direct effect of these policy measures has been a sharp deterioration of public budgets. In the EU the average public-sector deficits increased from 0.9 per cent of GDP in 2007 to 6.8 per cent in 2010 and over the same period the public sector debt jumped from below 60 to above 80 per cent of GDP (Chapter 5).
31This suggestion appears implicitly in IMF (2009a).
Government debt management and fiscal consolidation will certainly remain crucial issues in the public policy debate for several years. In Chapter 9 McCauley and Ueda notice that government debt management is often dis-cussed with reference to the question of whether central banks should proceed to extraordinary buying of government bonds. There are other relevant issues, such as how treasury debt management can contribute to maintaining the growth of bank assets, lowering the long-term bond yields or reducing net government interest payments, which are rarely analysed, despite the relevance they have in the post-crisis scenario. Based on the experience of the United States in the 1930s and Japan in the 2000s, McCauley and Ueda suggest that governments may indeed benefit from issuing long-term debt with interest rates tied to short-term bill rates in the confidence that monetary policy will keep yields low. As long as short-term rates remain low, treasuries will benefit from interest cost savings. When the economic activity quickens and interest rates rise again, they will benefit from higher taxes in compensation for higher servicing costs.
Chapter 10 addresses the crucial question of whetherfiscal consolidation may have a contractionary or expansionary effect. According to the conven-tional ‘Keynesian’ approach, a public deficit reduction, achieved either through a cut in government expenditure or through an increase in taxes, brings about a decline in aggregate demand and depresses the rate of growth of GDP. Fiscal consolidation may curb the recovery with the risk of pushing the economy back into recession. In recent years the Keynesian view has been challenged by several papers on both theoretical and empirical grounds.
Bilicka et al. in Chapter 10 present a survey of the theoretical literature and a critical evaluation of the empirical evidence. They identify several factors that seem to increase the probability of afiscal consolidation being expansionary and use them to attempt an evaluation of the possible impact of UK fiscal consolidation announced in 2010. However, the authors highlight a number of weakness in the empirical literature, which include the lack of very clear identification of both fiscal consolidations episodes and expansionary effects.
1.5 Conclusions
While there is little conclusive evidence that the tax system played a major role in triggering the tax crisis, there is growing support for making taxes play a prominent role in policy responses. A number of special taxes have been introduced and proposed to recover the cost of the ‘bailout’. These have involved both special taxes onfinancial institutions as well as taxes on bonuses.
The revenues of these special taxes have been quite significant, but the ultimate
incidence of these measures remains uncertain. It is also unclear whether these measures will continue in the future.
The ongoing debate has also highlighted that taxation may be used as a corrective instrument to complement prudential regulation of the banking sector. Some corrective tax proposals aim to curtail activity in the financial sector (‘Tobin taxes’), on the grounds that a large number of transactions are either speculative or of no social use. No international consensus has emerged to date as to the most appropriate approach. Without some of global coordi-nation, such measures would inevitably create competitive distortions across countries and market segments, as suggested by numerous past experiences.
The crisis has also drawn attention to a number of well-known weaknesses in the taxation of the banking sector, particularly in respect of loan loss provisioning, the relationship between financial and tax accounting, mark-to-market accounting, and value-added taxation. These issues are by no means new. The crisis has added saliency tofinding longer-term solutions. Unfortu-nately, after renewed attention to these questions, the political climate no longer appears propitious to address the needed structural reforms.
2
Culprit, Accomplice, or Bystander?
Tax Policy and the Shaping of the Crisis
Michael Keen, Alexander Klemm, and Victoria Perry
2.1 Introduction
This chapter considers channels by which tax distortions are likely to have contributed to excessive leveraging and otherfinancial market problems that came to the forefront during thefinancial crisis, and what this may mean for sensible directions of future tax reform.
This is an ambitious task. Economists are likely to be unpacking thefinancial crisis for years to come, and this may well lead to better understanding—relative, it must be said, to quite a low base—of the impact of taxation on the perfor-mance of modernfinancial markets. The discussion here1is simply afirst pass on the issue in the wake of the crisis: a health check on the most obvious possible channels of effect. Several such come to mind and are examined here. These include the corporate tax bias towards the use of debtfinance (considered in Section 2.2), tax distortions in housing markets (Section 2.3), and a range of effects through the development of complexfinancial instruments and struc-tures, including extensive use of low-tax jurisdictions,2 and on risk taking,
This is a revised version of IMF (2009a), previously published as Keen, Klemm, and Perry (2010).
We have benefited greatly from the comments and advice of Alan Auerbach, Carlo Cottarelli, Geoffrey Lloyd, Gareth Myles, John Norregaard, Jeffrey Owens, Joel Slemrod, and Peter Birch Srensen, as well as those of many colleagues at the IMF and seminar audiences in Milan and Toronto. Views expressed are ours alone, and should not be attributed to the International Monetary Fund, its Executive Board, or its management.
1 This chapter is based on IMF (2009a), which was prepared, in early 2009, for the Executive Directors of the IMF. An account of their views is at<http://www.imf.org/external/np/sec/pn/2009/
pn0976.htm>. For other discussions of tax issues raised by the crisis, see Lloyd in Chapter 8 and Slemrod (2009).
2 The terms‘tax haven’ and ‘low-tax jurisdiction’ are not used here synonymously: the former having come to be associated with illegal concealment of income, we use the latter term to
including through executive compensation (Section 2.4). The chapter also considers the activist use of tax policy to impact on asset prices (Section 2.5).
A central conclusion is that tax distortions do not appear to have triggered the crisis: there are, for instance, no obvious tax changes that explain rapid increases in debt in some parts of affected economies in recent years. But tax distortions may have made the crisis more painful, by, for example, leading to levels of debt higher than would otherwise have been the case.
Early alleviation of these distortions could have helped offset the factors that over the last few years led to higher leverage and other financial market problems—and would reduce exposure to future crises. Though not a culprit in the sense of having been a proximate cause of the crisis, tax policy was also no innocent bystander: an accomplice for sure, if an unwilling one.
The chapter describes that complicity and broad lessons for structural tax reform, to be undertaken once more pressing concerns have subsided, arguing for firmer action on long-standing (and deep-rooted) distortions. These dis-tortions have mostly long been recognized, but few countries have acted on them decisively. There remains much to learn, but one lesson of the crisis may be that the benefits from mitigating them are far greater than previously thought.
The benchmark for the analysis is taken to be neutrality in the tax treatment of alternativefinancial arrangements. Financial markets are marked by exten-sive informational asymmetries and other imperfections, so there may in principle be scope for corrective taxation. Some would argue, for example, that non-tax factors create an inherent tendency towards excessive leverage and that the tax system ought, therefore, actively to disfavour debt. But there is no consensus on the precise nature and magnitude of such inefficiencies, or on the relative merits of tax and regulatory responses in addressing them.
Neutrality of tax arrangements thus remains a core benchmark for policy evaluation and design in this, as in other areas of tax design. Of course, neutrality and efficiency considerations in tax design need to be tempered by distributional concerns, administrative and compliance capacity, and other considerations likely to vary substantially across countries. The impor-tance of neutrality is as a benchmark relative to which differential treatments may be evaluated, providing a check on special pleading and inadvertent side effects (from, for example, the use of tax measures to pursue objectives for which spending measures are better targeted).
highlight the perfectly legal avoidance opportunities that low tax rates (and/or narrow bases) may create: see Section 2.4.2.
2.2 Debt bias and other key tax distortions to corporatefinance Tax is one of many determinants of corporatefinancial policies. In a world of complete markets, perfect information, and no taxation, the parcelling of returns between equity and debt claims has no real consequence. Informa-tional imperfections, however, introduce considerations that can lead to a determinate choice. Issuing debt, for instance, can help constrain managers in their self-interested use of free cashflow (though there may be other better-targeted incentive structures to achieve that). But tax considerations are also critical: with interest payments deductible against the corporate income tax (CIT) while equity returns are not,firms have an incentive to issue debt until the expected tax benefit is just offset by the increase in expected bankruptcy costs. While the focus in what follows is on the debt bias this can create, taxation can distort other margins offinancial choice too—such as whether and when to realize capital gains or losses—and some of the issues this creates are also considered.
2.2.1 Assessing tax distortions tofinancial policies
The heart of the issue is the almost ubiquitous practice of allowing interest payments, but not the cost of equity finance, as a deduction against CIT.3 Leveraged buyouts (LBOs) are a prominent instance of the use of interest deduct-ibility, but the potential tax incentive to debtfinance applies more generally. The consequent bias towards debtfinance is greater the higher is the effective CIT rate, since this means that more tax is saved as a result of the deduction. It will thus be lower, for example, forfirms that are, or expect to be, in a tax loss position:
since losses are not carried forward with interest, any future reduction in tax liabilities has lower present value (PV) than an immediate deduction.
Levels of corporate indebtedness appear to have increased in recent years. In the UK, bank lending to non-financial companies increased from the mid-1990s from around 20 to nearly 40 per cent of GDP in 2007 (Bank of England 2008), and the aggregate ratio of debt to the replacement value of capital for non-financial corporations rose from around 30 per cent at the turn of the century to about 50 per cent in 2006 (Bank of England 2007). In the eurozone, the ratio of non-financial corporate debt to GDP rose from around 50 per cent to 66 per cent between 1998 and 2006 (ECB 2006). Debt–equity ratios appear to have been more stable in the USA—where they also tend, historically, to be lower than in other
3 The original rationale for this was a legalistic one, the view being that the corporation is so entwined with its shareholders that payments to them should not be deductible, whereas payments on debt are to true third parties and so should be. In economic terms, of course, both kinds of payment represent a return to capital, and it is their combined treatment at corporate and personal levels that matters. Shaviro (2009a) discusses further.
countries4—at around 40 per cent since 2003 (Board of Governors of the Federal Reserve System 2008). Manyfinancial institutions, of course, took on very high leverage prior to the crisis, with investment banks, for example, commonly operating with equity only 3–4 per cent of assets (and in some cases much lower).
LBOs, marked by especially heavy use of interest deductions, increased substantially up to mid-2007. Post-acquisition interest deductions under these schemes can be so large as to eliminate CIT payments for several years.
There is also likely to have been an indirect effect in encouraging otherfirms to increase their borrowing to defend against possible LBOs. Many LBOs cross national borders, moreover, and so are characterized by complex structuring intended to minimize tax liability and in some cases exploit opportunities for
‘double dipping’.5 Between 2003 and 2006, the amount raised by private equity funds,6which arrange most LBOs, increased aboutfivefold, to around
$230 billion (UK House of Commons, Treasury Committee 2007); and between 2000 and 2007 their share of merger and acquisition activity in the USA rose from 3 to nearly 30 per cent (US Government Accountability Office 2008).
Personal taxes on interest, dividends, and capital gains may also affect the choice between debt and equityfinance (with a distinction, in the latter case, between finance by retaining earnings and by selling new shares). Box 2.1 provides a detailed discussion of the tax factors affectionfinancing decisions.7 The key conclusions are as follows:
The taxation of interest income at personal level offsets to some degree the tax advantage at corporate level.
Finance by retained earnings, since it leads to an appreciation of the share price, is less attractive the higher is the effective rate of capital gains tax (CGT). Commonly, however, the effective CGT rate is low, largely because gains are typically taxed when they are realized rather than as they accrue, so that the tax liability can be reduced in present value by deferring realization (the‘lock-in’ effect).8
4Davis and Stone (2004), for example, report a ratio of debt to the market value of equity ratio of 28% for the non-financial corporate sector in the USA in 1999, relative to a G7 median of 59%.
Reflecting the magnitude of corporate liabilities, however, the ratio of corporate debt to GDP in the USA, at 46%, is close to the G7 median of 0.50.
5That is, taking multiple interest deductions: by, for instance, borrowing in a (high-tax) country to acquire equity in a subsidiary located in a low-tax jurisdiction that then lends to another subsidiary in a third country (see Mintz 2004).
6Private equity and hedge funds are partnerships, so are taxed not at entity level but by ‘flow-through’ to the partners (raising issues related to the tax treatment of the general managers that are discussed in Section 2.4.4). Hedge funds typically do not push debt down to corporations, so this leverage issue does not arise.
7For a more complete treatment, see, e.g., Auerbach (2002).
8In addition, capital gains are often charged at a lower statutory rate the longer assets are held (as in the USA, and until 2008 in the UK and Germany); and, in the USA, CGT can be avoided by holding assets until death.
Dividend taxation raises the cost of new equity finance. It does not in principle affect that of retentionfinance: in a choice between (1) retaining current profits and distributing them later, and (2) distributing them now, the dividend tax has to be paid in either case, and so—though it reduces shareholders’ net income—does not affect the relative attractions of the two. The dividend tax matters for new equityfinance, however, since the funds to be invested are not already trapped within the corporation.
Many countries allow some integration of personal and corporate taxes to mitigate this effect, by providing an explicit credit (as under imputation systems)9or charging a lower rate than is applied to interest income.
Box 2.1. TAXATION AND THE COST OF CAPITAL
The after-corporate tax rate of return r that a company needs to earn in order to generate the post-tax return required by those investing in it, when the gross interest rate is R, dependson the marginal source offinance, as follows:
Debtfinance. Interest deductibility means that to pay lenders interest of R the com-pany need earn only an after-CIT return of
r ¼ ð1 TCÞR; ð1:1Þ
where TCis the rate of CIT.
Retentionfinance. As shown in the appendix to this chapter, the company needs to earn
r ¼ 1 TR
1 TG
R; ð1:2Þ
where TRis the shareholder’s personal tax rate on interest income (relevant because their alternative to leaving money in thefirm is to lend it out) and TGthe effective rate of CGT (relevant because of the gain that retaining earnings will generate).
New equityfinance. As also shown in the appendix, in this case:
r ¼ 1 TR
1 TD
R; ð1:3Þ
where TDis the rate of tax on dividends at personal level.
In practice, a key margin of choice is that between borrowing and retaining earnings.
Comparing (1.1) and (1.2), borrowing will be tax-preferred to retention if 1 TC< ð1 TRÞ=ð1 TGÞ, or
TC> ðTR TGÞ=ð1 TG). ð1:4Þ For instance, at a CIT rate of 30%, and with interest taxed at 40% and CGT at 20%, debt is preferred. Retentions would be preferred, however, if gains were taxed at 14% or less.
9 These were common in Europe, but have become less so in recent years, partly because of complexities in dealing with cross-border investments but also as decisions of the European Court
While high-income individuals may prefer equityfinance, for others—includ-ing tax-exempt institutions and non-residents—the corporate-level tax advan-tage to debt dominates. Tax-exempt investors—pension funds, charitable foundations, and, in many cases, sovereign wealth funds10—clearly prefer debt finance: for them indeed there is a clear arbitrage gain in lending to tax-paying corporations and taking the interest untaxed. In addition, for non-resident investors, not liable to domestic personal taxes, the deductibility of debt finance is critical. Tax exempts are quantitatively important. In the UK, pension funds and insurance companies held around 30 per cent of all equities in 2006, and non-residents—probably subject only to withholding taxes—held 40 per cent. Direct holdings by resident individuals, in contrast, were only 13 per cent. Some put the comparablefigure for tax-exempt equity holdings in the USA at around 50 per cent. The scale and active management of the tax exempts may give their tax interests heavy weight in corporate financial decisions.
These distortions11 create advantages to the use of debt measurable in hundreds of basis points. Table 2.1 shows, for G7 members, the costs of the three sources of corporatefinance in 1990 and 2008; the upper panel relates to investors facing top marginal tax rates and the lower to tax-exempt investors—the two extremes. It shows the proportion of the gross market interest rate available to investors that a company needed to earn, after CIT, to meet the after-tax return required by those investors. At a 10 per cent interest rate, for instance, in 1990 a Japanese corporation needed to earn 6.25 per cent after CIT tofinance borrowing (if its marginal shareholder paid at the highest marginal rate) but 8.42 per cent on retained earnings. Even for top-rate taxpayers, debt is cheaper than new equityfinance in almost all cases, and, except in Canada, Germany, and the UK, it was cheaper than retention finance too. For tax-exempt investors, of course, debt is always tax preferred.
Table 2.1 also suggests that the tax advantage to debtfinance has in most cases fallen since 1990. The trend reduction in statutory CIT rates—the
of Justice have suggested that the Community’s non-discrimination rules require member states to provide credit for CIT paid in other member states. Australia and New Zealand retain full imputation, and Canada partial.
10While practice varies, sovereign wealth funds are generally exempted on their passive investments.
11Analyses of the kind above leave unclear how equilibrium is reached infinancial markets, since incentives for tax arbitrage—borrowing infinitely large amounts to pay infinitely large dividends, for example—will remain unless tax rates happen to meet particular ‘knife-edge’
conditions for all investors. Elements of an answer (which also revolve around the nature of any equilibrium, given, for instance, the likely non-unanimity of shareholders with different tax positions as to the best policy for thefirm to pursue) include non-linearities in marginal tax rates (progressivity of the personal tax as stressed in M. H. Miller (1977), and the effective rate of corporate tax falling as more debt is issued, for example), heterogeneity of risk attitudes across investors, and legal and other constraints on short-selling (analysed, e.g., in Auerbach and King 1982).