Osborne right on UK debt addiction
George Osborne’s plans to break the British addiction to debt have drawn protests from some business groups. He should not be put off. If a Conservative government with him as Chancellor can offer the quid pro quo of a cut in the rate of corporation tax, business should welcome the move.
Under today’s rules, British businesses have every incentive to finance themselves by borrowing: not only is interest typically lower than the return that shareholders demand, but all interest is tax-deductable. This anomaly was criticised as long ago as 1978 by James Meade, the Nobel laureate, but the position has worsened since then. Pension funds used to be able to reclaim the tax on dividends, but that concession was removed by Gordon Brown in 1997. As has recently become painfully obvious, this regime has significantly increased financial instability.
Given the impact on corporate finances, such a fundamental shift needs careful management. It cannot be done quickly, and an acute recession is not the best time to impose it, but it might be a good time to signal that it’s coming. Business is risky, and equity has proved itself over time as the best way of raising the finance to back it.
Among the critics of any threat to interest relief is the British Venture Capital Association, the trade body for private equity, the industry that has turned equity in its businesses to little more than option money. Typical capital structures ensure that the corporation tax bill is minimal, while even a small rise in operating profits can translate into massive gains for shareholders. If things go wrong, losses fall on the providers of the debt.
Banks which provided the debt have been burned by their exposure to over-leveraged companies. Unfortunately, they cannot be relied upon to remember the lesson once the current conditions fade into history. A tougher problem lies with multinational businesses. The UK allows companies to offset interest on debt raised anywhere in the world, at the cost of its corporate tax base, which has encouraged them to come here. Osborne’s plan to reduce the deductibility of overseas debt risks sending them away again, so he needs to tread carefully.
The carrot is a cut in corporation tax from 28 percent to 25 percent or as far below it as he can afford. Each cut reduces the attraction of higher gearing and the complex (and expensive) devices needed to maximise the current tax relief. Given the improvement lower corporation tax would bring to Britain’s competitiveness, the price of lower interest deductibility is well worth paying.