August 17, 2017 - This week, there was more news out of Washington. We speak, of course, of tax reform.
In late July, the Administration, House and Senate released a relatively broad statement on tax reform, parsed by Latham and Watkins here. Perhaps we all yawned. But earlier this week, House Ways and Means Committee Chairman Kevin Brady said that tax reform will happen this year. Ratcheting it up a notch, White House Chief Economic Advisor Gary Cohn said “We are going to hit the ground running literally this month on tax reform”, adding, “We hope we can get taxes down between now and Thanksgiving”.
To be fair, Thanksgiving might be aspirational for a Washington that has not seen excessive bipartisan achievements thus far. But if there is broad tax reform, it could have a significant impact on the loan market. Below we discuss tax reform, focusing on the potential end of interest deductibility (which we believe still is on the table). And, bringing it home, we discuss the possible impact on investment grade and speculative grade borrowers.
To give some historical context, the interest deductibility issue long predated President Trump’s plan (which currently is silent on the issue) and the House GOP Blueprint. Our recent reading on the economic impact of interest deductibility includes articles from 2012 and earlier. (Indeed some footnotes cite Nobel Laureate Merton Miller’s tax views in 1977.)
To begin with a philosophical view, a 2013 article by a former Democratic Senate Finance Committee tax counsel and Treasury assistant secretary for tax policy walks through the rationale for keeping corporate interest deductibility. A few key observations: First, business interest expenses are a cost of deriving income – i.e., an ordinary business expense – and should be deductible to measure income properly. Second, critics say the tax code favors debt financing through interest deductibility and disadvantages equity financing through double taxation of dividends. Most tax experts agree that double taxation is, well, inequitable. However, most also say that equating the roles of debt and equity in corporate finance is fallacious. They serve different purposes that warrant different treatment in measuring corporate income. Moreover, the fix is to remove double taxation of dividends, not increase taxation of interest. Third, a number of administrations have suggested that interest deductibility encourages overleveraging and financial distress for companies. In fact, a number of academic studies suggest that corporate financial distress could increase if interest deductibility is removed because the cost of financing would increase materially.
In addition to philosophical arguments in favor of interest deductibility, there also is the question of its impact on corporate investment. The 2013 tax note also suggests that the removal of interest deductibility will reduce investment, even if overall corporate tax rates go down. And a November 2016 Goldman Sachs research paper expands this thesis. It looks at the trade-off between accelerating capex depreciation and removing or reducing interest deductibility. Ultimately, the Goldman paper suggests that this trade-off could increase investment in year one, but then reduce investment in the following years. Net-net, investment declines.
So that might not be good. But, more parochially, what does this mean for the loan market. To that end, in late July, Moody’s released an update to its March “Debt and Taxes” piece. This time, it just looks at the combined impact of i) a lowered corporate tax rate to 20%, ii) immediate expensing of capex and iii) the removal of interest deductibility. Using a sample with an average 1,500 companies per year, Moody’s calculated the impact both on investment grade and speculative grade companies, as well as reviewing the general impact by industries. The big takeaway: All investment grade industries benefit from this three-pronged cocktail of tax reform. However, only one spec-grade industry – auto – comes out better due to tax reform. All other spec-grade industries do worse. Unsurprisingly, sectors with higher debt/EBITDA ratios and higher interest costs relative to EBITDA are hit the hardest under tax reform. In particular, gaming, technology, healthcare and consumer services sectors are particularly hard hit (see charts on p. 5 and 6 for sector details).
The rationale for the winners (IG) and losers (spec-grade) should be obvious. Investment grade companies incur more taxes relative to EBITDA than spec-grade companies (15% vs. 4%), and have lower interest expenses relative to EBITDA (7% vs. 26%). Thus, the loss of interest deductibility is particularly hurtful for spec-grade companies, and is not counterbalanced by a lower overall rate. Interestingly, the trade-off between immediate capex expensing and loss of interest deductibility actually is a net negative for both investment grade and spec-grade companies.
Ultimately, while tax reform might not be the most interesting thing coming out of Washington, it definitely bears watching for leveraged lenders and borrowers.