(Leverage: amount of debt that a company uses in its capital structure.  This is called leverage because it effectively multiplies, or leverages, the equity owners’ gains or losses.)  Over the last few years we have seen firsthand how over-levered companies can create an unstable environment.  Heavily levered firms such as investment banks, AIG, General Motors, and a number or other smaller companies have either declared bankruptcy or created serious risk for equity owners and others after the downturn in the economy.  So why are these companies so heavily levered?  Don’t the equity owners have an incentive to keep leverage lower to protect their positions?

The tax code in the United States calls for high corporate and personal tax rates, but partially offsets these high rates with deductions that corporations are allowed to take to lower their tax exposure.  Whether taxed at the corporate level (C-Corporations, think of most publicly traded companies) or only the personal level (S-Corporation, LLCs, LPs, et cetera, think of most small companies), the United States tax code allows companies to deduct interest expense from loans to the company from their earnings to lower their tax-basis.  As such, the more interest companies pay, the less they pay in income taxes.  This strategy, to offset the interest expense of debt with tax savings, is referred to as the debt-tax-shield (DTS).

For example, if a company borrows money at a 10% interest rate in a nation with no income taxes, the cost of the debt is 10%.  However, if the company borrows money in the United States with marginal income tax levels at 35%, the effective cost of debt is 6.5%.  The lower effective interest rate is a result of the income tax.  This lower effective interest rate inspires companies to borrow more money than they otherwise would because the cost of borrowing that money is lower, in relative terms, than it should be.  Furthermore, the higher the tax rate, the more incentive companies have to take on debt.  Consider a 50% marginal tax rate, under which out 10% debt would effectively cost 5%.  This artificially increased debt load encumbers companies and the entire economy with more risk.

This is just another instance where the government serves to distort markets.  This is by no means a call to remove interest expense from taxable deductions, as that will do nothing since companies will find other creative ways to reduce their cost of capital under whatever tax structure may be in place.  Instead we should be rid of income taxes, or at least lower the income tax rates.