Tax Analysts Blog

Debt Fears Increase, UK Could Limit Interest Deductions

Posted on Dec 2, 2009

If there is another financial crisis no one can claim they were not warned. In the minutes of its November Federal Open Market Committee meeting, some board members worried about "the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking." The mini-crisis with quasi-sovereign debt in Dubai temporarily rejuvenated investors' fears of another possible meltdown. These concerns have translated into higher risk premiums on debt issued by financially weaker governments, like those of Greece and Ireland. Yesterday's Financial Times had an article warning that state governments' deficits could put "significant cracks" in the $3 trillion municipal bond market. And in John Kay's column today we are reminded that avoiding the short-term pain of default on government-backed debt can lead to long-term inefficiency.

But it is rapidly rising corporate debt that could present the biggest problem. While credit from banks to small business is growing increasingly scarce, there is a "seemingly insatiable demand for corporate debt." ("Junk Bonanza for Private Equity," Wall Street Journal, Dec. 2, 2009.) Another article from the FT warns that there may be a problem refinancing corporate debt next year and the following year as interest rates rise: "With over $6,000bn in bonds maturing in 2010 and 2011, an almighty crowding out effect –- as issuers of all hues try to raise cash –- could pose one of the biggest risks for the global recovery."

One popular deal right now while rates are low is the "dividend recap." Under this practice companies owned by private equity firms sell debt to pay their owners cash dividends. ("Concerns Grow Over Overheated Debt Market," Financial Times, Dec. 2, 2009). This leveraging up on low-grade debt is a prescription for financial fragility that will ruin these companies if the economy fails to recover on schedule.

The man likely to be the U.K.'s next Chancellor of the Exchequer, Conservative George Osborne, has proposed limiting deductions on corporate interest to pay for a reduction in the U.K. corporate tax rate. "I believe the time has come to look again at the generosity of interest deductibility in our corporate tax system," he said in March at his party's annual conference. "By reducing tax breaks for debt we could potentially fund a significant reduction in the headline rate of corporation tax –- a key determinant of our international competitiveness."

The Obama Administration and Congress should also consider limitations on interest deductions to help pay for a reduction in the corporate tax rate. At a minimum the Volcker tax reform task force should include it in its catalogue of options.

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