We seem doomed to another round of monetary “stimulus” from the Fed and the European Central Bank, at a time when real interest rates are already substantially negative. This has caused crazy leverage all over the global economy, with such madness as Boeing (NYSE:BA) in a highly cyclical business, operating entirely without stockholders’ equity. Very well, if we can’t get the monetary madmen at the world’s central banks to raise interest rates to their proper level, let’s find a fiscal solution to the problem, which will also reduce the world’s yawning budget deficits. I propose a leverage tax.
Central banks’ funny money policies have produced many winners and losers over the last decade. Among the losers have been ordinary people, who do not have access to cheap leverage, earn derisory returns on their savings and find themselves priced out of the market when they need to move house. Any new taxes should thus not be imposed on ordinary people; they have suffered enough from central banks’ mistakes.
The big winners from central bank policies have been the very rich, who have access to cheap sources of leverage in large quantities and above all companies, both private and public, whose borrowing costs have been artificially reduced, access to leverage artificially increased and share prices (and hence value of bosses’ stock options) pushed into the stratosphere.
In addition, workers in poor countries have benefited, because cheap money reduces the premium that borrowers in those countries normally pay for their borrowing and increases their access to international capital. Of course, in some cases, poor country governments have borrowed inordinate amounts of money and then wasted it all – one thinks of the Macri government in Argentina, for example. However, workers in poor countries are already poor, and should generally not be burdened with additional taxes; in any case, the rise in global protectionism is already making life more difficult for them.
There is no question that in all wealthy countries except Germany, additional taxes are necessary. Leftist governments have been seduced by Keynesian “stimulus” theories to widen budget deficits almost without limit, and the sluggish growth caused by funny-money interest rate policies has prevented the usual fiscal drag that narrows them again. If there were any prospect of reversing funny money, one might hope for that reversal to improve the situation (though the increased interest costs on government debt would limit any improvement) but with no such change in view, higher taxes are necessary. They should be levied on the beneficiaries of funny money policies, the very rich and corporations benefiting from cheap debt, not on ordinary people who have suffered from those policies.
Given these realities, a leverage tax, in the form I will explain, is the best solution to the problem. An ordinary tax on debt, at a flat rate, would penalize ordinary people who borrow to buy a house, and would add costs to companies that run their businesses on a sound, properly leveraged basis. A leverage tax is better; it would increase steeply as leverage increases, so that the games-players of the last 20 years, who have been subsidized by the world’s central banks, would be especially penalized.
The simplest form of leverage tax would be based on a company’s liabilities, but at a graduated rate depending on the company’s leverage. For example, the tax might be payable at 1% per annum of a company’s liabilities for a company whose liabilities equaled its stockholders’ equity. In general, the company’s tax would be x% of its liabilities, where x was its leverage ratio of liabilities to tangible equity. If liabilities were only half equity, the tax would be levied at a rate of ½%; if liabilities were 3 times equity it would be levied at 3%. All liabilities would be included in the liabilities calculation, so that accounts payable and deferred tax would be treated in the same way as debt. In this way the tax would be based on the company’s true leverage, including all items. In the equity calculation, only tangible equity would be included, so capitalizing intangibles and goodwill would not save tax.
The only problem then would be how to extend the liabilities tax concept to individuals and financial institutions. For individuals, the tax should be payable at a flat rate 0.5% of liabilities up to a level of perhaps $5 million, after which a leverage formula like that on companies could be used, based on net worth. Details of net worth would be included in the individual’s annual income tax return (it’s only 1 more form!) and the tax calculated as if the individual were a corporate entity. For authorized banking institutions, the tax should be assessed at half the corporate rate, but other finance companies without a banking license would pay it at the full rate, thus penalizing hedge funds and other leveraged speculators.
With total non-financial domestic debt of $27 trillion in 2018, the leverage tax, supposing an average rate of 1%, would yield $270 billion annually, a very decent down-payment on the $1 trillion annual deficit. It would also add to the cost of borrowing, thus partially negating the effect of the Fed’s foolish interest rate policies. Most important, it would be targeted at those entities that have been led by low interest rates to behave most damagingly.
Over-leveraged companies would be forced to return rapidly to a reasonable balance sheet position. Indeed, extreme cases with negative net worth, such as Boeing, would be subjected to an infinite tax rate, which ought to get their attention. Assuming the new tax was brought in with a year’s notice (i.e. to begin on January 1, 2021 if legislation were passed today) it would simply be necessary for Boeing, for example, to carry out a substantial equity financing between now and January 2021 to bring its balance sheet into proper shape and comply with the law.
Based on Boeing’s latest quarterly figures and its market capitalization of $211 billion, an equity issue of $50 billion should be readily feasible, diluting its share capital by only about a quarter. That would increase Boeing’s tangible equity from negative $10.9 billion to plus $39.1 billion. If the new capital all went to reduce Boeing’s liabilities correspondingly, they would be $66.9 billion after the issue (in practice, some of the issue might be used to increase Boeing’s cash balance or engage in new capital investment). Based on those figures, Boeing’s leverage tax rate would then be 66.9/39.1, or 1.71%, and its annual leverage tax would be $1.14 billion, not an excessive burden of 11% of 2018 earnings of $10.5 billion, although the additional share issuance would dilute earnings per share by an additional 25%. The important change would be that Boeing would be properly capitalized after the change, and properly protected against any forthcoming downturn in its business.
Economically, the leverage tax would greatly reduce the leverage in the U.S. economy, and the cost and danger of the next recession. It would directly attack the increase in debt, which has spiraled in the last 24 years since interest rate policies were loosened, thereby reducing over-consumption and risk. However, it would be less recessionary than almost any other tax increase of its size, since it would attack primarily the very rich and the corporate sector, both of which have benefited disproportionately from the last decades of funny money.
Sectorally, the tax would hit real estate hard, deflating the overpricing that has become apparent in large coastal cities such as New York, Los Angeles and San Francisco (such a tax would also have a useful effect in Britain, finally deflating London house prices). By causing a sharp decline in house and apartment prices at the top end, the leverage tax would paradoxically make houses and apartments in general more affordable, enabling Millennials to get on the property ladder (the flat leverage tax below $5 million would have less effect than the graduated tax at higher levels, while still encouraging borrowers to de-leverage). President Trump would hate it for this reason, but tough; it would be good for the economy, which most of his economic policies are but his interest rate views are not.
The tax would hit overleveraged banks and financial institutions hard, thus increasing the safety of the financial system. It would in particular be applied to Fannie Mae and Freddie Mac, thus reducing those unnecessary behemoths’ incentive to play games with their implied Federally guaranteed balance sheets. However, the tax would also hit hedge funds, preventing them from leveraging up their balance sheets and causing financial panics like that of Long-Term Capital Management in 1998.
In terms of corporate behavior, the tax would be a heavy disincentive to the recent excess of share buybacks, which have inflated management’s stock option returns while decapitalizing companies. It would also discourage overpriced acquisitions, since the goodwill charge would directly affect net worth, boosting the tax charge.
The tax’s one danger to the corporate sector would be from the relatively novel accounting practice of forced fixed asset write-downs, especially prevalent in the mining sector, which could potentially push companies into gigantic leverage tax liabilities at a time when their businesses had suffered a downturn. Pressure should be brought on the accounting profession to abandon this practice, which has made it very difficult to carry out comparative financial analysis on such companies, because you don’t know which have suffered spurious write-downs and have no idea of assets’ replacement value.
The best solution to two decades of mistaken interest rate policies would be to reverse them, thus restoring health to the global economy. However, a leverage tax, raising large amounts of revenue for the overstretched federal budget and targeting precisely the unworthy winners from the past two decades of financial casino activity, would be a very good second-best solution.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)