Reforms to Tax on Debt: Caution Advised!
A series of articles in the Economist propose a radical revision of existing capital and debt structures. The newspaper explains that it considers subsidies on debt holdings offered by governments worldwide to be ‘senseless’. As ever, the articles present thought-provoking and valuable insights regarding the way in which these subsidies affect borrowing habits and therefore wider society. However, I would like to suggest that any reforms be approached warily for two reasons. Firstly, as many in PE will observe, any such changes will be hugely complex and disruptive throughout the finance industry. Secondly, and potentially more importantly, this disruption would likely spread to curtail investment in innovation across the western world: the issue of how these reforms will affect various borrowing and innovation ‘cultures’ globally must therefore be taken into account.
The main contention within the Economist’s pieces is that by offering tax relief on both mortgage debt (in many countries) and corporate borrowing (in almost all), governments ‘distort’ the global economy in favour of these borrowing practices. As a consequence, it is argued, private individuals and companies alike focus too much attention on borrowing and reducing the cost of the debt they incur, rather than concentrating on more positive economic activity which creates wealth and stimulates good business practice. The leader of these articles urges governments to act fast in phasing such subsidies out, seizing the opportunity provided at this time of low interest rates.
My first reason for suggesting that any such abolition measures should be treated with caution is that they would involve levying new taxes on interest which would completely change the landscape of operations for the financial industry as a whole, and Venture Capital and Private Equity in particular. VC and PE, and the benefits they bring to innovation rely on obtaining secure funding at good rates. As a result, should the current structures be abolished (effectively raising taxes on debt), these industries would be subjected to ‘massive disruption’, a fact the Economist acknowledges in part in another article. This change would also have a direct negative impact on the stock-market.
Arguably more significant, however, than the knock-on effects of the reforms on PE itself would be the broader impact on the innovation and financing sphere throughout most of the countries the Economist discusses. This difficulty becomes clearer when we consider how financial cultures vary geographically. Borrowing cultures, by which I mean factors such as attitude to debt, vary globally and will make achieving consensus among different national systems much harder to achieve. To provide an example, one need only look at home-ownership within Europe. This varies significantly from country to country; whilst in Russia it runs at 84%, in the UK it is almost 20% lower at 65%. Such differences not only reflect bottom-line variation in the availability of tax relief on mortgages, but also mark very different cultural approaches to taking on debt in order to buy a home.
If such differences exist within Europe then the discrepancies, and therefore the challenges, in successfully changing the system will be greater still when viewed on a global level. With the disruption caused by reforming entire debt and finance structures, PE and VC would be left less able to operate, meaning that innovation in many places would suffer from a lack of investment. As a result, reforming countries would be left exposed to competition from locations further afield which would be much less likely to participate in any reform process. One example of the potential effects of this is highlighted in a previous edition of the Economist which reports on China’s increasing competitiveness in biotechnology. The Middle Kingdom’s growing prowess across the sciences, a sort of technological ‘great leap’, shows that there are several places in the world which would happily rise to take the place of any reduction in western innovation which would result from a shrunken western PE sector.
In light of all this, PE and related businesses will be willing to defend their ability to secure the finances they require. This is key in order to ensure the continued viability of PE’s efforts to access and provide capital where it is needed most, for innovation and development in the markets where it has carried out its most successful projects. Some of the issues around attitudes towards debt which the Economist highlights are valid, but any reforms must be made cautiously to avoid curtailing PE’s ability to operate.