Debt and interest
Debt plays a huge and vital role in the modern economy. But excessive borrowing can be
a destabilising force as debtors risk finding themselves unable to repay their creditors, a
bad situation for both parties. For most people, interest – the cost of borrowing – acts as a
disincentive against becoming too indebted. Companies and landlords however are less affected
as they benefit from tax reliefs on interest payments, a feature of the tax system that encourages
them to load up on as much debt as they can manage.
Rental property advantage.
All landlords used to be able to deduct mortgage interest costs entirely from their rental
income when working out their taxable profits, giving them a substantial tax advantage
over owner-occupier mortgage-holders. That deduction started to be phased out for
individual landlords in 2017-18 and as of 2020-21 it has been replaced with a less
generous tax relief [link 109].
Under the old system, landlords could simply deduct the entire cost of mortgage interest
payments on rental properties as a business expense, reducing their overall taxable
profits. This deduction is still available to companies which may encourage more landlords
to incorporate [link 110]. Incorporating their rental property portfolio allows landlords to continue to
fully deduct interest payments from their profits, while also conferring other tax advantages,
including paying Corporation Tax instead of Income Tax on rental profits, which comes at a
lower rate, as well as potentially avoiding a large Inheritance Tax bill if they pass on their
portfolio. Incorporation does require the newly established company to purchase the
property from the landlord, which could mean incurring a large up-front tax bill from stamp
duty and capital gains. However if the portfolio is to be kept over a sufficiently long time, the
future tax savings may nevertheless make it worthwhile [link 111].
The new system offers individual landlords a tax relief rather than a deduction. Mortgage
interest costs can no longer be deducted from their rental incomes. Instead, all landlords
can claim a tax reduction equal to 20% of their mortgage interest costs, regardless of the
rate of tax they pay. Mathematically this works out as exactly the same benefit for basic
rate taxpayers, but in the higher rate bracket the benefit is effectively halved and for
additional rate taxpayers the loss is even greater. Additionally, the fact that the relief is now
applied after calculating profits, rather than by deducting interest costs from rental incomes,
means that landlords with mortgages will end up reporting higher profits, potentially giving
them a higher marginal rate if their interest deductions were keeping them in a lower
bracket [link 112].
Under the new system individual landlords still gain a significant tax relief on mortgage
payments so they continue to have a potential advantage over owner-occupiers, even if the benefit
is reduced for landlords with high rental incomes. Companies are the big winners.
In addition to paying a lower rate of tax, they retain the most generous tax
deductions, which gives them an edge over both owner-occupier households and
unincorporated landlords.
Generation Rent.
Even with the interest tax relief for individual landlords having been cut back, the legacy of
that policy is still apparent. Recent decades have seen a boom in the private rental sector,
with younger generations in particular much more likely to be renting and less likely to own
a house with a mortgage than in previous decades. From 2007-2017 alone the number of
households in the private rented sector rose by nearly two-thirds, from 2.8 million to 4.5
million. This represents a rise from 13% of all households to 20%. Since 2014 the private
rented sector has been larger than the comparatively stagnant social rented sector.
Meanwhile, the proportion of households with a mortgage has dramatically fallen from 37%
to 28%, falling behind those who own their homes outright in 2013 [link 113].
This transformation has been particularly concentrated among younger generations, but it
does not just affect the very youngest – some of the most dramatic changes have occurred
among the relatively middle-aged. From 1997-2017 the proportion of people aged 35-44
who had a mortgage fell from about two-thirds to half, while the proportion renting privately
rose from less than one-in-ten to one-third [link 114]. It also has not just affected those on low
incomes. The proportion of people aged 25-34 with incomes in the middle 20% who own
their own home has fallen dramatically from 65% in 1995-96 to just 27% two decades later.
A key reason for this decline has been the sharp rise in house prices relative to incomes:
between 1995-96 and 2015-16 the median ratio between average house price and the
annual household incomes of young adults aged 25-34 doubled from 4 to 8 [link 115].
The rise of buy-to-let mortgages has likely played a big role in pushing up house prices.
Fostered by the Housing Act 1988 which introduced Assured Shorthold Tenancies, the
buy-to-let mortgage expanded in particular after the 2008 Financial Crisis when demand
for owner-occupier mortgages slumped. The tax deductibility of mortgage interest
payments allowed buy-to-let landlords to outbid owner-occupiers for properties. This led to
a vicious circle, where fewer properties were affordable for first-time buyers so more young
adults were forced to rent for longer, creating even more demand for private rental
properties, which encouraged buy-to-let landlords to buy even more [link 116]. The reduction in
mortgage interest tax relief since 2017, as well as an increase in stamp duty on additional
properties which was introduced in 2015, has led to a cooling off in the buy-to-let market,
with new purchases falling throughout the 2015-19 period [link 117]. This goes to show how these
tax advantages were fuelling the growth of private rented portfolios.
This may not necessarily result in the decline of the private rented sector, however, as the
tax advantages retained by companies could mean that there will just be a shift in the
composition of the sector as individual landlords exit and corporate landlords enter
(perhaps including some of the former transforming themselves into the latter).
In 2015 the returns on investment for private and corporate landlords were roughly equal, but over
2016-19 corporate landlords have enjoyed more than twice as much growth in their
returns [link 118]. The absolute number of landlords has fallen recently, while the average portfolio
size of those still in the market has grown [link 119]. Meanwhile, the share of homes let by a
corporate landlord has risen from 9% in 2015 to 12% in 2019. In particular, the Government
has provided material support for “build-to-rent” schemes, including previously offering
direct financial support [link 120] and later simplifying its treatment within the planning process [link 121]
in order to encourage developers. Specifically supporting this kind of corporate expansion
into the private rented sector suggests the Government may see this is as a way to tackle
the UK’s housing crisis [link 122] and the tax advantages still enjoyed by corporate landlords may
have been deliberately preserved to incentivise this.
Corporate debt.
Corporation Tax is charged on a company’s profits so qualifying business costs can be
deducted, reducing the company’s taxable liability. This includes financing costs such as
the cost of making interest payments on outstanding debt. This produces a strong
incentive for companies to raise capital by borrowing rather than via equity financing
(selling shares) which does not enjoy such a tax advantage. This arguably tips the scales
towards riskier financing strategies: companies experiencing difficulties can suspend
dividend payments on shares, but not interest payments on debts, without going bankrupt [link 123].
However, a greater amount of debt in general risks creating bubbles and monetary instability.
The growth of corporate debt was given an intellectual grounding by the Modigliani-Miller
(or “M&M”) theorem which was developed in 1958. Contrary to previous belief that
corporate debts reduced the value of a company, the two economists Franco Modigliani
and Merton Miller argued that the market value of a company is determined by the present
value of future earnings and has nothing to do with its capital structure. Therefore, whether
a company finances itself via debt or equity (issuing shares) does not impact its value [link 124].
This model originally assumed away many real-world frictions, including taxes. However,
when developed further to include such complications, it actually shows that the tax-
deductibility of interest payments makes indebted companies more valuable than
un-leveraged ones, provided that the value of the tax benefits exceeds the risk of default [link 125].
If two companies are equally profitable then one that funds itself primarily via issuing debt
will be taxed less than one which reinvests its (taxable) profits or issues (taxable)
dividends. This implies, furthermore, that (existing) shareholders benefit from a company
becoming more leveraged as it is likely to raise the value of their assets.
These findings, combined with the steady decline of interest rates since the 1980s and a
belief that indebtedness actually disciplined companies to act more responsibly [link 126], led to an
increasing preference for companies to engage in debt-financing. In the United States non-
financial corporate debt has doubled since the early 1980s [link 127]. This has been associated with a
dramatic decline in assessed corporate creditworthiness with the number of top
investment-grade ratings stagnant or falling, while high-risk corporate “junk bonds” have
boomed from a tiny fraction of the market in 1980 to about 40% of ratings today. The
number of top-drawer triple-A ratings issued to companies by Standard & Poor’s has fallen
from 65 in 1980 to just 5 today, despite the total number of companies rated rising from
about 1,500 to nearly 5,000 [link 128]. Many companies have increased debt financing in order to
buy back their own shares, making clear the preference for debt financing to equity [link 129]. In
the UK, listed corporate net debt has risen by nearly 75% between 2010-11 and 2018-19
up to a high of £443.2 billion or about one-fifth of GDP and 2.6 x operating profits [link 130]. To sum
up, companies worldwide are increasingly indebted and that debt is, on average,
increasingly risky.
If the corporate debt bubble is burst by a shock that cuts the revenues of many companies
or drives them out of business altogether (a global pandemic, for instance...), then a great
deal of corporate debt owed by over-leveraged firms will be defaulted upon. Like the impact
of over-leveraged banks hit by the collapse of the sub-prime mortgage market in 2007-08,
such an event could cause a great deal of financial distress as a vast amount of money
simply disappears, blowing holes in the balance sheets of financial institutions and other
investors. The cost of this would inevitably be spread across the whole economy in the
form of a credit crunch and in all likelihood a severe recession.
Debt and monetary instability.
As mentioned above, debt plays an incredibly important function in the economy, and in
particular it plays a central role in the modern monetary system. The Bank of England itself
states, contrary to some popular misconceptions and orthodox economic theories, that
most money is created by commercial banks making loans. When an individual or
corporation borrows from a bank, they are not passed money from somewhere else, as
would be the case if someone was lending cash to a friend . You never see money
taken out of your current account or savings with a note from your bank saying, “sorry, we
lent this to someone else”. Instead, borrowers are simply credited with new money. This
means that banks are not merely intermediaries, nor do they “multiply up” base money, but
are instead the primary source of money creation through lending [link 131]. The Bank of England
estimates that about four-fifths of all money is created by commercial banks versus just
one-fifth created by the state in the form of reserves or cash [link 132].
This means that the amount of money in the economy is largely determined by the supply
of and demand for loans.
Bank lending is only constrained by regulations and the apparent prudence of making any given loan.
Likewise, borrowers are constrained only by the willingness of banks to lend to them and their
own assessment of whether borrowing is a good idea. Policies which incentivise borrowing are
therefore likely to encourage more lending and, as such, more money creation. Furthermore,
since interest rates are used by banks as risk premiums – if a borrower is thought to have a greater risk
of defaulting they are charged a higher interest rate – tax relief on interest costs disproportionately
incentivise riskier borrowing: they offer a greater benefit to borrowers paying high interest
rates.
While a great deal of debt is prudent and proves to be a good investment for both parties,
incentivising excessive borrowing is not just bad for specific debtors and creditors but risks
creating monetary instability. Debt bubbles fuelled by accommodative policies mean a
rapidly expanding supply of money floating around the economy creating inflationary
pressures, while, if or when the bubble bursts, banks are forced into contracting the money
supply, causing a credit crunch in which prudent and irresponsible borrowers alike
struggle.
Ending interest deductibility.
A fair and efficient tax system should not discriminate between different taxpayers and
different ways of allocating capital without good reason. The ability to deduct or offset
interest costs against tax liabilities gives landlords a significant advantage in the housing
market, helping them to outbid first-time buyers and driving prices up in the process. It is
effectively a public subsidy to landlords [link 133], a group of asset owners who don’t appear to
need the help. Private rental payments in the UK have been steadily growing since the
financial crisis [link 134], and as of 2019 totalled approximately £52 billion [link 135]. Individual landlords
have already had their mortgage interest deductions slashed and that does seem to have
slowed down the buy-to-let boom.
Is the solution to extend the mortgage interest tax deduction to all mortgage-holders,
including owner-occupiers? Evidence from other countries suggests this might not be
much of an improvement. A 2007 study of mortgage interest tax reliefs across five
European countries found that they are highly regressive, mostly favouring high-income
households, and that their abolition – including the abolition of owner-occupier mortgage
interest relief in the UK by 2000 – reduces post-tax income inequality [link 136]. The mortgage
interest deduction available to homeowners in the United States, one of the most well-
known tax reliefs there, is often justified on the basis that it encourages homeownership.
However, the data does not back that up [link 137]. Instead, it appears to inflate house
prices and possibly house sizes, again, largely to the benefit of the relatively rich and
wealthy [link 138].
The simplest solution would be to abolish the tax relief on mortgage interest payments
altogether. This could cause disruption in the short-term, as house prices would likely fall
and many landlords would seek to exit the market. Although, when houses are so expensive
and in relatively short supply, this would not necessarily be a bad thing! In the long run,
the evidence presented above suggests this would be an equitable move that reduces
distortion in the housing market.
The same kind of accusations can be levelled against the corporate interest tax deduction.
What is the justification for a benefit that subsidises corporate borrowing and, as such,
incentivises companies to leverage up, rather than build up a reliable base of equity
funding? The behavioural impact of this distortion may make many companies more
profitable, but also more fragile.
The Economist is a perhaps surprising advocate of abolishing corporate interest
deductions. They have argued that it is an overly expensive subsidy and that it encourages
the excessive accumulation of debt [ink 139]. Abolition would certainly hurt a lot of businesses,
which have made extensive use of the tax advantage, resulting in many companies having
to substantially restructure themselves, or go bust. It would also be difficult to implement
without some degree of international cooperation and alignment, as otherwise multinational
corporations could simply shift their borrowing into other jurisdictions where the deduction
still exists [link 140]. Once again, the long-term benefits of a corporate environment, which does not
give preferential treatment to indebtedness, could prove to be worth the short-term
disruption.
If tax relief on interest is to be abolished, now is perhaps the ideal time to do it while
achieving minimal disruption. Across most of the world, interest rates have been generally
declining since the 1980s and today sit at remarkably low levels. According to the OECD,
the neutral real rate of interest (i.e. the inflation-adjusted rate which should theoretically
maximise employment) has been below 0.5% since the 2008 crash [link 141]. Since 2008, central
banks, including the Bank of England, have been engaged in extraordinary monetary
policy efforts to keep interest rates low in order to try and stimulate growth, efforts which
have been redoubled in 2020 in response to the Covid-19 crisis [link 142]. The upshot of this is
that interest rates are low and likely to remain low for a while, meaning that the additional
cost which individuals and companies would face if denied tax relief on interest costs
would be proportionally lower than in previous periods of higher interest rates.
Fundamentally, a properly functioning capitalist system should not need or want to
incentivise borrowing. Borrowing is justifiable and prudent if it is likely to generate sufficient
returns, and would-be borrowers and lenders do not need any state encouragement to
make mutually beneficial loans. Giving a preferential tax treatment to debt is not likely to
encourage prudent lending which would have happened anyway, but rather to encourage
pushing the margins and making risky decisions.
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110 https://www.gov.uk/government/news/changes-to-tax-relief-for-residential-landlords
111 https://listentotaxman.com/uk-tax/tax-guides/should-you-incorporate-or-not.html
113 https://www.ons.gov.uk/economy/inflationandpriceindices/articles/ukprivaterentedsector/2018
114 https://www.ons.gov.uk/peoplepopulationandcommunity/birthsdeathsandmarriages/ageing/articles/
livinglonger/changesinhousingtenureovertime#increases-in-the-private-rental-sector-at-middle-ages
115 https://www.ifs.org.uk/uploads/publications/bns/BN224.pdf
116 https://www.mortgagefinancegazette.com/features/influence-buy-let-uk-housing-06-02-2017/
117 https://www.mortgagefinancegazette.com/features/decade-buy-let-04-05-2020/
118 https://www.bondmason.com/bondmason-listed-landlord-index
119 https://www.hamptons.co.uk/research/pr/2020/Lettings-Index-January2020.pdf/
120 https://www.gov.uk/government/collections/build-to-rent-guidance-and-allocations
121 https://www.gov.uk/guidance/build-to-rent
123 https://www.ft.com/content/426c1465-9561-4300-8d3e-2430e4124c93
126 https://hbr.org/1989/09/eclipse-of-the-public-corporation
127 https://www.ft.com/content/27cf0690-5c9d-11ea-b0ab-339c2307bcd4
128 https://www.ft.com/content/87efe5a9-4cb6-493b-a31a-f9efd5ddd242
129 https://www.cnbc.com/2019/07/29/buybacks-companies-increasingly-using-debt-to-repurchase-
stocks.html
130 https://www.linkassetservices.com/our-thinking/debt-monitor-2019
131 https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-
economy.pdf?la=en&hash=9A8788FD44A62D8BB927123544205CE476E01654
132 https://www.bankofengland.co.uk/knowledgebank/how-is-money-created
136 https://www.iser.essex.ac.uk/research/publications/working-papers/euromod/em2-07.pdf
137 https://fas.org/sgp/crs/misc/R46429.pdf
138 https://taxfoundation.org/home-mortgage-interest-deduction/
139 https://www.economist.com/briefing/2015/05/16/a-senseless-subsidy?fsrc=nlw%7Cnewe%7C18-05-
2015%7CE
140 https://www.economist.com/finance-and-economics/2017/02/02/what-if-interest-expenses-were-no-
longer-tax-deductible
141 https://www.nber.org/digest/nov19/secular-stagnation-and-decline-real-interest-rates
142 https://www.bankofengland.co.uk/coronavirus
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