The Debt-Equity Distinction in a Second-Best World
This Article discusses the time-honored but outdated tax law distinction between corporate debt and equity. Economic and legal commentators and the Treasury Department have made various proposals to eliminate the debt-equity distinction. The theory of the second best posits that eliminating an economic distortion does not necessarily increase efficiency if other economic distortions remain.' Policymakers cannot simply assume that eliminating the distortionary debt-equity distinction will automatically increase efficiency because other distortions in the income tax will remain. This Article evaluates a number of the proposals to eliminate the debt-equity distinction, taking into account numerous distortions that are likely to remain in our tax system.
The problems associated with the debt-equity distinction have gotten worse in recent years. Part II traces the origins and evolution of the debt-equity distinction. The debt-equity distinction has its roots in the traditional, individualistic conception of debtor-creditor relations, which treats shareholders as the owners of the corporation and debtholders as outside suppliers of capital. Things have changed since the early part of this century when Congress created the debt-equity distinction. For starters, public ownership of debt and stock has be- come widely dispersed, creating a separation of corporate ownership and control. The dispersion of investment led to the development of two alternative theories of the firm, investment theory and the new economic theory of the firm, both of which would treat debt and equity as qualitatively similar.
The recent explosion in financial contract innovation has laid bare the deficiencies of the debt-equity distinction. The traditional multi-factor case law tests for classifying debt and equity were created in the context of closely held corporations and focus on the relation- ship between the issuing corporation and the investors. The adventurers in the business, meaning those who expose their capital to the risks of the business, are shareholders; those who do not put their capital at risk are creditors. This traditional risk-based approach to classification simply does not make sense in an era in which (1) financial contract innovation allows parties to slice and dice risk and real- locate it in just about any way imaginable, and (2) the "risk premium" investors have historically required to invest in stocks instead of bonds has in recent years virtually disappeared. The discussion of financial contract innovation in Part II illustrates three potential costs associated with the debt-equity distinction: (1) complexity; (2) uncertainty; and (3) the creation of tax arbitrage opportunities. Part II also discusses two other inefficiencies caused by the debt-equity distinction: (1) "overleveraging;" and (2) the tax bias against investment in risky technology businesses that may disproportionately fuel economic growth.