Letter number 62 of November 2011


News : To reform the tax code?

In a triple context of excess public spending compared with income, the large amount of taxations compared with the wealth created, and sometimes their structure, and finally upcoming presidential or legislative elections (in Spain, the USA, France, Germany and Italy), taxation is a topic which is likely to remain in the news for at least another few quarters.

We had a dream. We were suddenly propelled into the position of Minister of Finance, with national representation and citizens who had all, for a long time, been avid readers of the Vernimmen. 

Let’s forget that taxation most frequently results from the accumulation of contingent measures that are heavily influenced by the economic situation, political will at a given moment and the weight of special interests. Let’s forget that taxation is never neutral.  What should we do?

Our ideas, which are void of any political influence as you will see, and which naturally take a financial approach, i.e., they adopt the point of view of the firm and the investor seeking to reason in terms of equity, go in the following six independent directions:

1. From a financial point of view, there is no reason why taxation of income on capital (interest, capital gains, dividends) should be different from taxation of income from work.

Despite looking very hard, we were unable to find any reason. We could certainly claim that such assets are often acquired using accumulated income from work and accordingly have already been taxed once, so they shouldn’t be taxed a second time. 

But this argument doesn’t hold much water as income from work spent on consumption is taxed a second time through VAT or sale taxes. The other argument often advanced, that capital is mobile but work is less so, and thus the former should be taxed less in case it flees, is rather cynical and does not encourage social cohesion. All the more so since governments more or less everywhere have the same budgetary problems, the mobility of taxation risks losing its attractiveness, especially with the persistent bad press that finance is receiving, movements here and there by the indignant, and calls by billionaires to be taxed more, which will not lead to lower taxation on income on capital.

2. From a financial point of view, there is no reason why income and capital gains should be taxed differently.

As it is often possible to transform one into the other through the capitalisation of interest (zero coupon loan (1)), or through the reinvestment in or buyback of shares which generate capital gains, it is best to avoid taking such decisions, which could have very serious economic consequences, for tax reasons when they should be taken for economic or financial reasons.

3. From a financial point of view, there is no reason why interest and dividends should be treated differently from a tax point of view, either within the company or in the hands of the investor.

Interest and dividends are the remuneration of providers of funds of the company, which uses them to finance its operating asstes. On the basis of what logic should the interest on debt be deductible from a company’s taxable income, when dividends are not? 

We can see here the influence of accounting which aims to establish net earnings accruing to shareholders. From this point of view, financial expenses are an expense and the dividend is a distribution of earnings of which it cannot by definition be deducted from an accounting point of view.

As taxation is not systematically aligned with accounting, we can very well conceive that it might be a good idea to stop using taxation to favour a company’s debt to the detriment of equity. This advantage given to debt is an open invitation to companies to behave recklessly as debt makes them weaker while equity makes them stronger (2).

Tax neutrality concerning the sources of financing could be achieved in two ways:

• make dividends paid tax deductible, just like interest is. Companies would be very likely to rapidly increase their dividend payout rates to 100%, then to carry out capital increases to reconstitute their liquidity.  From a financial point of view, such a change, which would return to shareholders the power to control cash flow, would be beneficial and would avoid problems of waste, i.e., investments made by managers with their own agendas (3). It would have the unacceptable drawback of reducing income from corporation income tax to zero. Only a part of this tax loss could be made up for at the level of shareholders as not all shareholders, not by a long shot, are local tax residents and so they are not taxed locally, or only very little through taxation withheld at source; 

• do away with the deductibility of interest. Germany introduced such measures partially a few years ago (for the fraction of financial expense exceeding 30% of EBITDA).  If ever there was a time to do it, it’s now when interest rates are low and from an historical perspective, companies are, on average, carrying small amounts of debt.

Technically, steps should also be taken to ensure that financial income is also not taxable in the amount of financial expense, in order to avoid unduly penalising those who borrow for the purposes of lending on (the parent company in a group, banks).  Only the interest margin (if it is positive) should be taxed. 
Similarly, at the level of the investor, we don’t see why the different types of income on capital (income and capital gains, interest and dividends) should be taxed differently (tax base, rate, reduction). The difference in risk borne by the investor does not appear to us, in itself, to be a good reason as it goes hand in hand with a difference in returns which justifies it and compensates it, without the tax authorities having to come to the rescue.

On the other hand, taxation of the investor, most frequently favourable to equity, can push individuals to take risks on equity, guided only by the lure of lower income tax, even though they cannot bear such risks. This reveals a certain irresponsibility on the part of the government. 

Finally, it is inconsistent to have a corporate tax system that encourages companies to take out debt, and an individual tax system that encourages individuals to invest in equity. Perhaps the lawmakers were seeking, either consciously or unconsciously, to re-establish neutrality of overall taxation between debt and equity, with taxation that is more favourable to equity at the level of the investor cancelling out taxation that is more favourable to debt at the level of the company?  If this is the case, the result has not been achieved.
Practice has shown us that a number of financial managers overvalue the tax advantage of debt and forget the negative counterparty at the level of investors who make them pay for this debt.

Practice has also shown us that unsophisticated individuals buy shares only for the tax advantage, which often turns out to be illusory (some stock markets are below their 1997 levels).

4. From a financial point of view, there is no reason to tax dividends paid to investors, when these dividends are being paid on earnings that have already been taxed once.

After all, the shareholders (or the equivalent) of companies that are transparent from a tax point of view (collective partnerships, UCITS) are taxed on their share of the earnings made by the company, without the company being taxed on the same earnings. Why should what is allowed for certain types of company not be generally extended? 

Governments are in fact well aware of this, since they create, do away with and then re-create mechanisms (tax credits then reductions in France, ACT in the UK, etc.), which partially limit this dual taxation. But even though the principle has been understood, all of these systems are highly complicated. A decision should simply be taken not to tax dividends. But what a challenge it would be to persuade the public that this would be a good thing!

Luckily we started out by stating a principle that would ensure that capital gains on equity (including those payable on stock options) or on debt, and interest on debt not tax deductible (government and local authority debt) were taxable according to the same system as salaries and wages.

5. From a financial point of view, there is no reason why profits that are reinvested should be taxed differently from profits that are paid out.

In the 1980s, Germany and France had tax systems that distinguished between profits on the basis of whether they were reinvested or whether they were paid out.  In France, profits that weren’t paid out, were taxed less.  In Germany, the opposite was true. 
Investment is not systematically something that must be favoured from a tax point of view.  We just need to think about situations of overinvestment (real estate in Ireland or Spain for example).  Similarly, paying dividends is not some evil act that should be punished using taxes in order to reduce it, all the more so since managers tend naturally not to need tax incentives to get them to reinvest rather than pay dividends.  On the contrary, it is a factor of capital mobility, a guarantee of a better allocation of this rare resource.  New sectors are continually emerging and most of them have to be financed using equity, given their risks.  If equity ends up being trapped within corporations for short sighted tax reasons, and invested like cash in the short term (and thus turned into debt), then it will be unable to play this crucial role in economic development.

6. From a financial point of view, we think that it would be good for taxation to break out of its neutral position in order to favour the long term rather than the short term.

In a society that is dominated by zapping and impatience, anything that encourages us to slow down and take a longer view would seem to be a very useful counterweight.  So, when computing tax on capital gains, the cost price of listed shares could be revalued each year on the basis of inflation.  This would be better than tax reductions that apply in a relatively undifferentiated manner.  The fact that many tax returns are submitted on-line now would make this relatively simple to introduce.

* * *

The combined application of these six independent principles is not easy, as there is a contradiction between, on the one hand, wanting the same tax treatment for dividends as for capital gains, and on the other, not taxing investors on their dividends paid out of after-tax profits, and taxing capital gains.

Let’s say that in an ideal world, corporations would be taxed on EBIT (plus exceptional items).  At the level of investors, capital gains of all types collected, and interest on debt issued by non-taxable entities (state authorities), would be taxed in the same way as salaries and wages.  Dividends would not be taxed as they come from net earnings which have just been taxed, and the same goes for interest on debt issued by taxable entities for which it would not be deductible from taxable income.  

* * *

We are well aware that taxation can be guided by consideration other than pure financial logic and we hope that the reader will forgive us this moment of escapism. 
(1) For more information, see chapter 17 of the Vernimmen.
(2) For more information, see chapter 14 of the Vernimmen.
(3) For more information, see chapter 27 of the Vernimmen.

Statistics : Corporate income taxe rates

The average corporation tax worldwide is 22.96% in 2011, down continually since 1993 (38%, but the former Soviet countries have brought the average down and also KPMG has extended its survey to a number of small countries which have low tax rates in order to attract investors). 

On average, all of the continents have contributed to this reduction, except Europe, where the average rate is up slightly by 0.1 %:

Research : Behaviour and financial decisions

Behavioural finance involves using the results of work done in the field of psychology in order to explain or predict financial behaviour.  It is a branch of behavioural economics, an area of research that is in full expansion, and which earned Daniel Kahneman and Vernon L. Smith the Nobel Prize for economics (1). Under the neo-classical theory of the firm, the manager is considered to be a mechanical optimiser of the value of the firm. Agency theory introduces the specific goals of the manager (different from those of the shareholders). Behavioural finance, for its part, considers that the psychological traits of individuals (and especially of CEOs), may guide their behaviour (2).

The article that we present this month (3) falls under this field of research.  This is an empirical study on the consequences of the psychological make-up of managers (CEOs and CFOs) on their decisions.  Three academics from a US university adapted a questionnaire previously used by experimental economists and psychologists, and submitted it to CEOs and CFOs in the USA and the rest of the world. (4). There are at least two reasons why their approach can be criticised: Firstly, it is difficult to evaluate the sincerity of the answers received, and secondly, only a static analysis can be drawn from the results.  It does, however, have the merit of permitting a direct analysis of the link between psychology and behaviour.

The results of this study show that the psychological traits of managers have a substantial influence on their decisions.  The authors were particularly interested in decisions relating to capital structure and external growth:

• With regard to capital structure, firms carry more debt when their managers are men (more often seen as being over-confident) and when they have professional experience in accounting or finance (which could provide them with better ability to run a debt-laden company).  When managers are optimistic, the proportion of short-term debt is higher (they believe that they’ll be able to refinance).
• In terms of external growth, firms carry out more acquisitions when the manager has a low risk aversion.  The result is statistically highly significant: the link between the psychological make-up of the manager and the external growth policy is confirmed.

Some of the other results of the vast study deserve attention:

• Managers appear to be much less averse to risk than the population as a whole (10% are “very averse to risk” compared with 64.5% for the whole of the population).  The wealth effect could partially explain this gap.
• CEOs are more optimistic than CFOs, and US managers are more optimistic than their European and Asian counterparts. 
• Managers with high risk aversion get a much larger fixed portion in their compensation packages, in line with the prediction of incentive theory.

What makes this article stand out is its methodology.  Most of the work done on this subject make (wrong) assumptions about the psychological traits of managers on the basis of their decisions.  By carrying out psychological tests on managers, Graham et al were able to show the correlations between psychological traits and decisions taken within the company.  Given the lack of dynamic analysis, it is impossible to show the direction of the causality.  Is it the managers’ psychological make-up that influences the capital structure and external growth policy, or is it the capital structure and external growth policy of the company that leads it to hire certain types of manager?
(1) For more details see Vernimmen.com Newsletter n° 28 of November 2007.
(2) For more information on these theories, see chapter 15 of the Vernimmen.
(3) J.R. GRAHAM, C.R. HARVEY and M. PURI (2010), Managerial attitudes and corporate actions, Duke University working paper
(4) The authors constructed their data base using subscriber data bases of reviews such as Chief Executive magazine and CFO magazine.

Q&A : CDSs and the cost of financing

Does a company’s implicit CDS rate at a given time represent its cost of credit at the same time?

In theory yes, in practice no.

Let’s remember that the Credit Default Swap is first and foremost an instrument for hedging against an issuer’s credit risk (1).  An investor seeking to protect himself against the risk of a bond issuer defaulting buys protection from a seller.

The buyer, like in an insurance policy, pays the seller for the duration of the contract, for example 5 years, a fixed quarterly amount, which, expressed on an annual basis as a percentage of the amount covered, constitutes the CDS premium (like an insurance policy premium).

So for example, at the end of October 2011, it would have cost 90 basis points to hedge against the risk of Danone defaulting, or €90,000 per year to hedge a €10m loan.

In the event of a credit incident, i.e., pronounced default of payment on time of interest or capital insured by a CDS, the buyer of the CDS pays the seller the quarterly premium prorated to the time since the last instalment paid and delivers the covered bond (i.e. the reference bond referred to in the contract) to the seller. In exchange he receives 100% of the face value of the bond from the seller.

Researchers have shown, using arbitrage as a basis for reasoning, that the CDS premium (2) should be equal to the spread of the bond with an equivalent maturity date.

The following examples show that this theoretical situation does not always play out in reality.  In general, the CDS premium is higher than the spread on the bond, but there are some counter examples:

The conditions necessary for arbitrage are, however, not always met.  Liquidity of corporate bonds is low as investors often hold onto them until they mature.

Given this low liquidity of the underlying amounts, which restrict the possibility of sale, investors seeking to protect themselves will tend to buy CDSs.  And they may be joined in doing so by those who hold credit on the bond issuer. 

Bondholders and bankers may also not have the same appreciation of risk, which is another source of difference.
Parallel to that, the Greek situation has also caused a lot of disruption.  Holders of Greek debt have seen their bonds lose 50% of their value, taking into account a market value, which is to be treated with caution, as the volume of transactions in this bonds has fallen off spectacularly, but which raises serious doubts over Greece's capacity to pay back 100% of 100% of its debts.

Nevertheless, since in the eyes of practice that governs CDSs, Greece has not formally defaulted, holders of Greek bonds cannot recover through CDSs what they are losing on their bonds.  So, hedging using CDSs has proved to be less efficient than expected.

Once bitten, twice shy, as the saying goes, and holders of other countries' debt who fear for its value are saying that even though a government cannot go bankrupt officially thanks to European solidarity, then the banks of these countries can go bankrupt.  And the CDS of a bank will be even more efficient as a hedging mechanism than that of the government.

Consequently, to hedge the risk on the bonds of this country, investors buy CDSs of the banks in this country.  The CDS premium is then disconnected from the spread paid on their bonds, all the more so since the underlying bank bonds are too illiquid to allow arbitrages to get the CDS premium and the spread to converge at equilibrium again.
(1) For more on CDSs, see chapter 49 of the 2011 Vernimmen.
(2) For a simple demonstration, see the work of Emmeline Travers by clicking here.