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Tax perk in danger

After all, the logic of allowing companies to deduct their interest payments against taxable profits was tenuous – and had been questioned – even when the public sector’s balance sheet was comparatively sound. Now that it is being wrecked, there is more reason to wonder why companies should have this perk; especially as removing it might perform a socially-useful function, albeit one that would favour some companies and penalise others.

That there is a hole to be filled is not in question. Since 1900, the biggest year-on-year drop in the UK’s output was 9.7 per cent in 1921; a year, incidentally, when the effects of a far more serious pandemic lingered. That drop will be nothing compared with what awaits us in 2020, according to the best guess from the UK’s Office for Budget Responsibility; the spending watchdog pencils in a 12.8 per cent fall. As a result, public sector receipts could drop by 15 per cent even while public sector spending rises by the same proportion. The effect is a £218bn deterioration in public sector finances.

True, there should be some bounce-back in 2021. Even so, the need for the government to tap additional sources of revenue may be overwhelming, particularly ones that are politically acceptable.

Removing interest payments from the list of companies’ tax-deductible expenses won’t be a game-changer for the state’s finances, but it would be useful. As a crude indicator, take the corporation tax paid by FTSE 100 companies in their latest full year. Excluding the four clearing banks, for which interest on debt gets mixed in with interest on deposits, the other 96 paid £32.4bn of interest. If that sum were dragged into the tax net and taxed at 19 per cent – the current rate of corporation tax – then £6.2bn would be raised.

Many more companies pay corporation tax than those of the FTSE 100, although the big cats are likely to pay the lion’s share. Tee-ing off from that £6.2bn, we might conjecture that the total take from ending the interest allowance could be £10bn. In the context of corporation tax revenue of £58bn in 2019-20, that extra is not to be sniffed at – it would fund a fair few state pensions.

A key part of the argument in favour of change is the conflicting tax treatment of the two main components of a company’s capital, debt and equity. Why should the cash costs of debt be an allowable expense when the cash costs of equity – dividends – are not?

Historical anomaly has much to do with it. When a company was perceived to be no more than the aggregate of its shareholders, then it was right they should bear the sole tax burden via the profits they extracted from their company. But that argument became redundant as soon as the temptation to tax profits at the company level became too powerful to resist, which was even before corporation tax was introduced in 1965. Now that company registers are dominated by institutional investors, representing many sources of saving, this argument has no resonance.

Nor does that obscure argument about tax incidence and tax burden. This says it is pointless taxing companies since they don’t actually bear the burden of the taxes they pay. They hand over the money but pass on the burden to the poor souls who can’t escape – the customers, suppliers and employees. While this is true to an extent, in practice it is impossible to know where the boundary between incidence and burden lies.

Of course, if one unintended consequence of axing the tax-deductibility of interest was that hordes of UK-registered companies upped sticks and parked themselves overseas, then that might be an argument in favour of the status quo. Most likely, it is a threat that the leveraged half of the UK’s private-equity industry would use. Yet the pleasure of watching private equity squeal is almost a reason in itself for ending the tax break.

Besides, there is a serious reason in favour of the change – that it will persuade companies to do what they should be doing anyway. Clearly the effects of the pandemic tell the average company what 2008-09’s financial crisis told the banking industry – that, to be viable, a company needs sufficient capital to protect itself against the most brutal of shocks; in other words, more equity, more cash and less debt.

Sure, the reduction in leverage implies that, on average, earnings per share would be lower than with the status quo. Against that, investors would demand a lower risk premium to put their capital into safer companies, so, on average, share ratings would be higher and, overall, value would remain much the same.

Yet some company values would suffer. Those looking especially vulnerable would be utilities and property companies, both of which are used to running on high levels of debt and – especially in the case of the latter – face a world where demand for retail and office space may be fundamentally altered. Then there are those in danger of becoming perennial weaklings, which carry high debt levels as a result. Within the FTSE 100, Vodafone (VOD), Rolls-Royce (RR.), perhaps even J Sainsbury (SBRY) might drop into that category. Lose their tax perk on interest and these unloved ones would become even more shunned.