CAMBRIDGE – After the financial crisis erupted in 2008, many observers blamed the crisis in large part on the fact that too many financial firms had loaded up on debt while relying on only a thin layer of equity. The reason is straightforward: whereas equity can absorb a business downturn – profits fall, but the firm does not immediately fail – debt is less forgiving, because creditors do not wait around to be paid. Short-term creditors cash out or refuse to roll over their loans, denying credit to financially weakened firms. Long-term creditors demand to be “made whole” and sue. Without cash, the firm fails.
Financial firms in the United States pay about 34% of their profits in taxes, and, while they can deduct interest payments to creditors from taxable income, equity is not taxed as favorably. Most countries have similar tax preferences for debt over equity, thereby encouraging financial and other corporations to use more debt, as financial analysts have long known.