Reviewing reports of last week, I see that buried in the details of President Obama’s corporate tax reform proposal is a rare gem. To be clear, the overall package — basically a reduction of the nominal tax rate in exchange for giving up some of the more egregious loopholes — seems an ok deal. But there is a piece of idiocy in the corporate tax code that hasn’t been addressed seriously since Jimmy Carter failed to get it fixed in 1977. This is the tax advantage of debt over equity.
This sounds dull, but it has a story behind it that is far more revealing about “private equity” than any of the blather you’ve already read about Mitt Romney and Bain Capital.
Imagine, for a moment, Company A with a million dollars in profit and a hundred thousand investors, each of whom paid a hundred dollars for a share. The company takes that million, pays taxes on it, and distributes the remainder to the investors. Say they pay 10% of their profits in taxes (what’s left of the 35% rate, after all the loopholes, and not an unusual number). If the company distributes all its profit as dividends, each shareholder gets $9, a 9% annual return on their investment, which isn’t bad at all.
Now imagine a Company B that also earned a million dollars more than they spent. This one has a hundred thousand bondholders, each of whom loaned the company $100 at 10% annual interest. The company sends $10 to each bondholder, and so reports zero profit, thus zero taxes. The shareholders in B? Who cares about them?
The structure of these two is pretty much the same: both companies sell their products, pay their expenses, and then distribute the money left over. But one calls those distribution payments “dividends” and the other calls them “debt service” and so the first company pays taxes, and the second does not.
What happens if the economy declines? Company A will simply send out less money in dividends. Company B will go bankrupt if it can’t meet its debt payments.
Clear enough? Now imagine some private equity vultures, I mean investors, notice that Company A has built up cash reserves of $10 million. They borrow $50 million to purchase Company A, which is now on the hook for $2.5 million per year. Since they’re only earning a million a year, they have to pay part of that debt service from their reserves, but they can do that for a few years. Also, they get to book a loss, which means they can ask the IRS to refund the taxes they paid for the previous two years. And since they can’t get enough back to make a profit, it’s very unlikely they will pay any taxes at all for a long time to come. They used to pay $100,000 in taxes every year, so over the life of the losses they’ll incur, taxpayers will subsidize the deal to the tune of over $2 million.
This is the point that lots of people don’t understand, or refuse to understand, about “private equity.” They way those outfits make money is usually by using the tax rules to their advantage, not by increasing corporate efficiency or streamlining processes. A company with exploitable assets could be one with an underutilized factory or intellectual property, but it’s more likely just to be one that has cash in reserve or that paid a big tax bill in the last couple of years. “Assets” like these are much more easily quantified than property and you can estimate them via public documents, something you can’t do with factory outputs or licensing fees.
In other words, that wave of leveraged buyouts that began in the 1980s and ended — well it hasn’t really ended — was largely subsidized by you and me. When RJR Nabisco was bought in 1989 for $21 billion, taxpayers ultimately paid more than $5 billion to the purchasers. This was not the free market at work, it was the tax code encouraging buccaneers like the folks at KKR, Michael Milken, and Ivan Boesky, along with Mitt Romney and Bain Capital. Without the tax advantage of debt over equity, very few of those leveraged buyouts could ever have happened.
Jimmy Carter’s economic team recognized the risk to American manufacturing represented by the tax preference for debt over equity, and addressing it was a central piece of his proposed 1977 overhaul of the tax code. But the change was opposed by business, and he dropped it. Ronald Reagan’s administration made a half-hearted attempt to fix it in 1984, but it went nowhere. Dan Rostenkowski, the longtime head of the House Ways and Means Committee, worked on a proposal in 1987, but it also died. George Bush, Sr., airily said, “I have no agenda on that. I’m always a little wary about the government trying to solve problems when, historically, the marketplace has been able to solve them,” and declined to do anything about the issue. Bill Clinton’s 1995 tax proposals contained a provision addressing the issue, but these were presented during the government shut down episode and did not make it into the final bill resolving that debacle.
So far as I know, that’s the last time there was a proposal on the congressional table to address what has been one of the most destructive tax policies on record. Over the past 30 years, our leaders, with only a few exceptions, have stood by as big finance has devastated our manufacturing sector, laid off hundreds of thousands of people, and done away with their well-paid jobs — and you and I paid for it. I know President Obama’s corporate tax proposal isn’t going to become law in this Congress, but fixing the tax code to eliminate the subsidy for leveraged corporate takeovers is important, and I’m glad someone has put it forward — again.