Although we are by no means out of the danger zone, eyes are starting to turn away from how the UK’s businesses can survive the Covid-19 crisis and towards how to rebuild the economy in the longer term.
However, there is a very real issue facing the UK economy as a whole: are our levels of corporate debt sustainable?
The UK government’s response to the coronavirus crisis, while understandable, was to make a plethora of loans available to business. For many this was a lifeline, but it had a knock-on effect. Corporate debt was very high before even the coronavirus crisis, and has risen sharply as a result of the government’s loan schemes.
Companies have been loaded up with levels of debt (£23.8bn in Bounce Bank Loans and £9.6bn under the Coronavirus Business Interruption Loan Scheme), which would be unthinkable were interest rates not close to zero.
TheCityUK Recapitalisation Group’s Interim Report, published at the start of June, predicted that by March 2021 UK businesses would have £100bn of unsustainable debt, approximately half of which would be owed by SMEs. This will be a significant barrier to economic recovery.
Corporate debt is not purely a financial issue — it is also strategic. The Jubilee Centre, a research institution focused on finding Biblical solutions to public policy challenges, has argued for a long time that investment is preferable to borrowing because investors and the business share the risks of failure and the rewards of success.
The result is that an investor is far more likely to support a business through a difficult period of trading than to take a short-term decision to realise its capital.
Debt, by contrast, creates fragility. Fixed repayments mean companies focus on surviving from day to day, rather than planning for the long term.
So how to redraw the map and get out of the current predicament? The government could start by removing the tax subsidy for interest payments, which would stimulate economic recovery by encouraging equity investment. This would both allow corporation tax to be reduced, and weed out the zombie companies carrying levels of debt that are unsustainable.
As things stand, companies receive tax relief on the interest payments on their debt, whereas money paid to shareholders as dividends is taxed. There is no economic rationale for this tax bias, which Robert Pozen of Harvard Business School has called “a senseless subsidy”.
The fact that companies are able to get tax relief on the interest they have to pay on their debt gives them a reason to borrow rather than to seek investment. The result is that there are lots of companies which have a small base of equity capital but carry high levels of debt.
Companies such as Boeing spend billions taking on debt in order to buy back their own shares. Companies owned by private equity firms take advantage of similar incentives. Large businesses have become projects in financial engineering rather than enterprises committed to the efficient delivery of the goods and services we need today and investing in developing the goods and services we will need tomorrow.
Xavier Rolet, former chief executive of the London Stock Exchange, argued in a 2017 article: “Our markets subsidise the debts of big business while starving small companies of capital”. Despite the fact that debt is fundamentally ill-suited to helping small businesses, SMEs in the UK managed to raise little in the way of equity finance. The average of £7.2bn a year raised through equity between 2017 and 2019 is only 30 per cent of the total already lent under the UK government’s Bounce Back Loan Scheme.
To return to the present crisis, we should view these challenges as a moment of opportunity. To do nothing would be calamitous, but there is a choice to be made between levelling the field between equity and debt either upwards or downwards.
An example of the levelling down approach, suggested in a recent letter to the chancellor, is to offer tax relief to those “angel investors” who invest in startups.
In contrast, a levelling up approach would make interest payments taxable on the same basis as shareholders’ profits — or better still, to abolish tax relief for interest payments entirely.
With interest rates currently so low, this is an unprecedented opportunity to make the change. Abolishing tax relief would allow a reduction in the level of corporation tax because of the larger tax base. Doing the two measures in combination would distinguish between overly indebted companies that need to be restructured through insolvency, and those businesses that would benefit from equity investment to fund their recovery.
Now, even more than during the financial crisis, is the time for us finally to come to terms with the reality that our debts are unsustainable and that fundamental reforms to risk-sharing and to taxation in our society are required in order for businesses and the households they serve to flourish.
Main image credit: Getty