The EU’s DEBRA proposal will do more harm than good due to flawed modelling and third country spillover

On 11 May 2022, the European Commission presented a proposal for a harmonised EU wide debt-equity bias reduction allowance (the DEBRA proposal).  To eradicate the preferential treatment of debt, the DEBRA proposal suggests rules for an EU-wide allowance for corporate equity combined with a new limitation on the deductibility of interest payments.

This blog summarises some of the points the Tax Justice Network raised in a new policy briefing on the EU Commission’s DEBRA proposal. The policy briefing explains why the proposal in its current form is bad policy and should not be adopted. This is not to say that debt-equity bias is not a problem in need of a solution. The solution, however, is an ‘A’-less DEBRA: a further reduction of interest deductibility, but without the granting of an allowance for corporate equity.   

Introduction: solving the great debt-equity distortion

It’s a problem in corporate tax systems as old as corporate tax itself: the debt-equity bias. Interest on corporate tax debt is deductible. By contrast, the cost related to equity financing in the form of dividends paid, cannot be deducted against profits. The tax savings inherent to interest deduction creates an incentive for companies to overly rely on debt financing. This is problematic because corporate debt can be a device for tax abuse, and excessive debt makes companies less shock-proof. In times of crisis, this increases the risk of insolvency and, as the IMF has argued, threatens global financial stability.

Broadly speaking, there are two ways to solve the debt-equity bias. On the one extreme, corporate tax systems could be reformed to treat equity like debt for tax purposes. This could be done by introducing what tax policy theorists call an ‘allowance for corporate equity’: a fictional tax deduction calculated in function of a company’s equity which mimics the deduction of a company’s interest cost. On the other end of the spectrum, corporate tax systems could be reformed to treat debt like equity for tax purposes. This entails the full non-deductibility of interest payments. Policy theorists refer to such a system as a ‘comprehensive business income tax’.

In practice, only a handful of countries have implemented some kind of allowance for corporate equity. The Tax Justice Network’s Corporate Tax Haven Index shows that in 2021, of the 70 countries analysed, 8 countries had a fictional interest deduction of equity in place, 6 of them being EU countries. Those countries that do so combine it with interest deduction limitation rules. Interest deduction limits are more widespread, especially after the adoption and implementation of the BEPS Action 4 minimum standard.

Both systems – an allowance for corporate equity, and non-deductibility of interest payments  – come with different properties. For one, the adoption of a corporate equity allowance type system fundamentally narrows the corporate tax base because it grants an additional tax deduction. This reduces countries’ tax revenues. A  comprehensive business income tax type system widens the tax base, thus increasing tax revenues. An asymmetric adoption of corporate equity allowance systems by only a few countries can furthermore induce new forms of tax abuse which is not always easy to tackle with anti-abuse measures, thereby putting additional pressure on tax revenues.

For these reasons, the Tax Justice Network’s Corporate Tax Haven Index gives good marks to those countries implementing the strongest interest deduction limitations (see Indicator 15). Countries introducing  corporate equity allowance-type fictional interest deductions for equity receive bad marks (seeIndicator 8). With its corporate equity allowance component and limited interest deduction, the EU Commission’s DEBRA proposal provides 27 EU Member States with implementation homework that is guaranteed to get them bad marks on the index. 

Misguided modelling and selective analysis

Aside from corporate equity allowance measures altogether not being recommendable, the EU Commission’s DEBRA proposal is also majorly flawed in its analysis and assessment of the different policy options available to solve the debt-equity bias.

The assessment is based on a selection of policy options which range from the one extreme of a self-standing corporate equity allowance (‘a hard ACE’, ie a notional interest deduction for all equity) without interest deduction limitation, to the other extreme of a full non-deduction of interest system. Not surprisingly, these extreme scenarios are discarded because the mathematical modelling shows their introduction would be too disruptive: a hard equity allowance is predicted to be too costly, and full non-deductibility of interest payments is predicted to be detrimental to international ‘competitiveness’.

The scenario of a self-standing corporate equity allowance (a ‘soft ACE,’ ie a notional interest deduction only for new equity) is also tested, yet the EU Commission’s preferred option is that of the ‘soft ACE’ combined with a limited  non-deductibility of interest payments. No good reason is given for this and there is no analysis of other valuable scenarios, like that of self-standing limited  non-deductibility of interest payments. Such a scenario would avoid the disruptive edge of full non-deductibility while avoiding shrinking tax bases and tax abuse risks associated with the equity allowance.

The problems go beyond just the selection of policy options for assessment. Assessment of the options is based on quantitative output provided by the CORTAX model. This input-output model, which makes quantitative predictions of corporate tax reform options on parameters like revenue cost, wages, investment and GDP, is unsuitable. Its predictions depend on assumptions that oversimplify economic reality. For example, the model does not consider the effect of a measure with negative revenue impact caused by the correlated cut in public spending. Other completely unrealistic assumptions are the underlying premises that all economic actors have full information, that markets reflect perfect prices, and that companies realising windfall profits will reinvest these gains in the economy rather than in the personal wealth of the owners (possibly outside the EU).

Most worryingly, CORTAX predictions are said to be accurate only in a scenario of economic growth. By the EU Commission’s own admission, exogenous reasons like wars, pandemics and the climate crisis make the results of the CORTAX modelling overly optimistic. Why, then, rely on its findings to discard some policy options but champion others? And why rely on a model that focuses on benchmarks like ‘investment’ and ‘growth’ but fails to assess other criteria like equality, impact on distribution and concentration of wealth and income, and other parameters that contribute to economic and political stability?

The EU Commission notes in the DEBRA proposal that ‘investment’ and ‘growth’ are linked with the ‘competitiveness’ of the EU, with ‘competitiveness’ being both a prerequisite for investment and growth, and a result of it. The Tax Justice Network has repeatedly called out the ‘competitiveness agenda’ as an ill-founded guise for the mere slashing of taxes while ignoring the fact that handing out tax cuts affects the quality of public services and tends to increase inequality, which in turn have a clear negative impact on economic performance.

Even the Biden administration called time on the ‘competitiveness’ myth in 2021:

“[A] consequence of an interconnected world has been a thirty-year race to the bottom on corporate tax rates. Competitiveness is about more than how U.S.-headquartered companies fare against other companies in global merger and acquisition bids. It is about making sure that governments have stable tax systems that raise sufficient revenue to invest in essential public goods and respond to crises, and that all citizens fairly share the burden of financing government.”

Remarks by Secretary of the Treasury Janet L. Yellen on International Priorities to The Chicago Council on Global Affairs, April 5, 2021.

A country with high tax levels and a well-performing economy are not mutually exclusive.

Fatally flawed altogether

In addition to the issues with modelling and analysis, the DEBRA proposal comes with other flaws: the lack of robust anti-avoidance rules, the negative spillover effects on the ability of third countries to achieve the sustainable development goals and reduce extreme poverty, and the inconsistency with current international efforts to introduce a corporate minimum tax.

As noted in the Tax Justice Network’s Corporate Tax Haven Index, corporate equity allowance systems are prone to abuse. Policymakers introducing equity allowance measures cannot but resort to combine its introduction with the adoption of specific anti-abuse rules. Without targeted anti-abuse rules, the equity allowance’s budgetary impact easily swings out of control. In its DEBRA proposal, the EU Commission notes that DEBRA comes with a set of ‘robust anti-avoidance rules’. One of the three specific anti-abuse rules in the proposal is said to target ‘double dipping’, a practice through which companies end up receiving two tax benefits in relation to the same capital by artificially increasing equity through specific intra-group reorgansation: the tax deduction of interest paid on a loan and fictional interest deduction based on the capital increase with the funds made available by the loan, or the other way around. The anti-double dipping rule prevents the inclusion of any equity increases in the DEBRA equity base as the result of loans between associated enterprises. However, this rule does not prevent multinational enterprises from centralising their genuine equity in European group companies and having those companies grant internal loans to third country group companies. In other words, double dipping is fine as long as the genuine equity base is located within the EU.

The partial anti-avoidance rules are symptomatic of the EU Commission’s lack of consideration of spillovers of DEBRA on third countries. The proposed DEBRA is defended, amongst others, because of its positive contribution to the sustainable development goals, and in particular SDG 8 (‘Promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all’) and SDG 9 (‘Build resilient infrastructure, promote inclusive and sustainable industrialisation and foster innovation’) within the EU.

The assumption is that windfall gains from the DEBRA allowance will result in higher investment in innovative companies. Not only is this reasoning a textbook Laffer curve fallacy, it also ignores the fact that negative spillovers of DEBRA on third countries might make DEBRA’s global net contribution to the development goals a negative one. Negative DEBRA spillovers might hamper lower income countries’ efforts to attain SDG 17.1 which encourages countries to strengthen domestic resource mobilisation. It is also at odds with the Addis Ababa Action Agenda on the implementation of the development goals. The Addis Agenda emphasises the importance of greenfield foreign direct investment for sustainable development. By triggering corporate debt increases in third countries, DEBRA does exactly the opposite.

Finally, the DEBRA proposal also lacks any coordination with other corporate tax policy reform efforts by the EU in the recent past and pending for the near future. For example, not a word is mentioned in the DEBRA proposal on the possible interaction of the measure with the EU’s Minimum Tax Directive, which implements the OECD/IF’s Pillar Two Global Anti-Base Erosion (GloBE) rules. The DEBRA’s ACE component has a lowering effect on companies’ effective tax rates. This means that in certain scenarios, the DEBRA tax cut might trigger the minimum tax rules. This ‘rob Peter to pay Paul’ effect of DEBRA is symptomatic of an isolated reform proposal that is launched without any coordination or eye for the global corporate tax landscape. It is also at odds with the EU Commission’s own BEFIT strategy which pleads for a coherent approach to corporate taxation in the EU, with reduced compliance costs for taxpayers.

Concluding observations: towards an A-less DEBRA

The DEBRA proposal is not a good plan and adopting it would be a mistake. The debt-equity bias in corporate tax is a genuine problem that requires an EU-wide solution. But such a solution should be part of a lock, stock and barrel overhaul of business taxation in the EU. It should not figure in in a directive that lacks coordination with other relevant corporate tax policy development and policy objectives.

It’s clear that any type of corporate equity allowance measures come with a budgetary cost and with budgetary uncertainty. Steering clear of equity allowance means steering clear of the pressure of tax abuse and of negative spillovers on third countries. The EU Commission should consider the adoption of an ‘A’-less DEBRA: a regime composed of a self-standing interest deduction limitation without an ACE component. Such a regime would tackle the debt-equity bias but without handing out tax cuts through the granting of an allowance. Additional revenues can be used for targeted public spending, creating both social stability and ensuring an attractive climate for sustainable business. EU countries receiving top marks on the Tax Justice Network’s Corporate Tax Haven Index for implementing an ‘A’-less DEBRA can only be seen as an added bonus.