Measures to strengthen equity
The COVID-19 pandemic and national and international containment efforts are having a significant impact on the global economy. Companies worldwide will be increasingly threatened by a higher risk of insolvency in the coming months and years. In Austria, too, the crisis has exposed problems in the equity base of domestic companies. The decline in turnover has exacerbated the situation of low equity capitalization both directly and indirectly through the valuation of assets. In addition, although credit guarantees, the adjustment of credit lines and deferrals of levies have significantly reduced the acute risk of insolvency, the problem of servicing these liabilities remains. Accordingly, measures to strengthen the equity base of domestic companies are to be welcomed. This will strengthen their resilience to future crises and can help to reduce the financing costs of investments.
The financing structure of companies is determined by a variety of factors that affect both the company itself and the market in which it operates, as well as the institutional environment. Empirical studies suggest that key institutional factors such as legal certainty, the structure of creditor protection, the quality of regulation, the definition of accounting standards, disclosure requirements and regulations for pension funds all play a role. In addition, the tax environment is decisive for the financing structure and therefore the equity base of companies. In particular, the tax treatment of equity and debt capital income at company level as well as interest income and distributions at individual level should be mentioned here. Specific regulations such as the type of taxation of profit-sharing and employee participation can also influence the financing structure.
The equity base of non-financial companies in Austria has improved continuously in recent years. In an international comparison, however, the proportion of debt capital remains high and is in the top third of the country comparison. This means that the ratio of debt to equity in Austria is around twice as high as in Sweden or Switzerland, for example, the countries with the best equity base in the country sample. In a comparison of Austrian industries, accommodation and food services, construction, real estate and other business services have particularly low equity ratios. In most tax systems worldwide, interest on borrowed capital is deductible from the tax base when determining taxable profit, whereas this does not generally apply to interest on equity.
This difference is seen as discrimination against equity financing and contributes to a correspondingly high level of debt financing. The idea of a notional return on equity is to eliminate this distortion by allowing companies to charge a notional interest rate on equity and deduct this for tax purposes. The international overview shows that such systems have been introduced in a number of countries, including in Europe. However, the design differs considerably in some cases.
One fundamental difference is whether the entire equity qualifies for the return on equity or only the increase in equity. There are also differences in the amount of the interest rate, which is often set as a surcharge on the yield of government bonds or on a debt capital interest rate. In some countries, the return on equity can be claimed in full for tax purposes, while in others it is only subject to a lower tax rate. In Austria, too, there have been regulations in the past that have provided for preferential tax treatment of interest on equity.
In addition, the introduction of a notional return on equity is associated with tax relief due to the reduction in the tax base. From a tax point of view, Austria has fallen somewhat behind its peer countries in terms of corporate taxation over the years. Taking interest on equity into account would strengthen the competitive position and crisis resilience of domestic companies.
The economic effects of a specifically designed notional return on equity in Austria were determined. In particular, it is assumed that interest is paid on equity at a premium of 2 percentage points over the money market interest rate and that the corresponding interest reduces the tax base in full (up to a cap). In the main scenario, it is assumed that interest on equity is capped at EUR 1 million, so that the maximum tax relief for corporation tax amounts to EUR 250,000 per year. The measure reduces the effective tax rate on corporate profits, thereby lowering the capital utilization costs for financing via equity (in particular retained earnings) and creating additional investment incentives.
According to the results of the simulation with the PuMA model, real investments increase by more than 0.5% compared to the base scenario without return on equity. The improved capitalization increases the productivity of employees and thus the demand for labor and employment. The higher productivity also boosts disposable income and thus private consumer demand, which is around ¼ percent higher as a result of the measure. GDP is around 0.2% higher than in the baseline scenario without reform, which corresponds to additional value added of around EUR 800 to 900 million per year.
The reform also strengthens the equity base of domestic companies, reducing the ratio of debt to equity by 4 percentage points and increasing the equity ratio by 0.8 or 1.7 percentage points, depending on the scenario. As a result of the positive economic effects, public revenues also increase, particularly in terms of social security contributions, wage and income tax and consumption taxes, meaning that around half of the reform is self-financed in the medium and longer term through higher revenues.
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The model simulations make it clear that a return on equity improves the (equity) capitalization of companies, which is positive in view of the below-average equity capitalization of companies in an international comparison. In addition to a notional return on equity, other measures can also help to strengthen the equity base of Austrian companies. These include, in particular, regulatory measures, tax regulations in certain areas such as employee and profit-sharing and promoting a social environment that encourages more risk-taking. A better equity base strengthens the resilience of companies, as it enables them to cushion the impact of a sharp drop in sales over a longer period of time. Overall, a notional return on equity has a correspondingly positive economic impact.
