Systematic Bias and Systemic Injustice: (Updated) Preliminary Thoughts

With the revelation of the federal income tax returns of Donald Trump there has been much wailing and gnashing of teeth about the small amount of income taxes he paid in many years (much less than me, FWIW). That one involved in multiple businesses is able to shield revenue from taxable income should come as a surprise to precisely no one. That's how tax accountants make a living. (It's certainly no surprise to the well-heeled among Joe Biden's  supporters.)

More to my point, however, is the adage that you get more of what is subsidized. Congress has chosen to make interest a deduction from revenue to create taxable income. As I explain below the fold, I think this is a bad idea. But until the law is changed, any privately-held business will rationally opt to fund its operations via debt (with deductible interest) and not equity (with non-deductible dividends).

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Over the recent months much has been written about systemic injustice. Much less about systematic injustice. You can see a comparison of the frequency of each expression as a search term here. I don't think the two expressions are interchangeable but the difference is not immediately apparent.  Friend Ben Inman has suggested that

There does seem to be a common distinction between the adjectives systematic and systemic. ... . In general, it seems that systematic would refer to intended design of a process or to the consistent intended results of an action or series of actions. ... Systemic is contrasted as that which characterizes the system or has an effect upon the system as a whole. (Emphasis added.)

I'm not sure I agree but for now which is which is unimportant. What is important is to distinguish between the intended goal of a social practice--such as legislation--and its effect. The first can be laudable and yet produce unjust results. We need not--at least we are not obliged--to impute the unjust results to unjust intentions (much less evil motives) of the lawmaker. In other words, we can have systematic justice* but systemic injustice.

David McIlroy has recently written a fine piece, The Taxing Question of Unsustainable Corporate Debt. McIlroy is a visiting professor at the Centre for Commercial Law Studies at Queen Mary University in London. His day job is as a barrister and he active with the Jubilee Centre, a UK think tank seeking to "build bridge to business, seeking to connect the world of the Bible with the world of contemporary society."

To McIlroy's point: as many have observed, "Companies currently get tax relief on the interest payments on their debt whereas money paid to shareholders as dividends is taxed." In other words, interest payments to lenders are tax deductible to the corporate entity while dividends to shareholders are not. To the best of my knowledge this has been the case since governments began to tax business income. And from one perspective it makes sense: interest is like any other expense of operating a business such as wages, utilities, and the cost of goods sold. If a tax is to be on income, not sales, then the tax legislation must provide for a set of expenditures to deduct from gross revenue to establish (net) taxable income.

Unlike interest payments, dividends have not been understood as an expense of operation; dividends have been conceptualized as a distribution from (net) income after a corporation reserves some funds for a rainy day (or pandemic) or future investment. At least that's how accountants conceptualize the matter, and legislators and tax authorities simply followed suit.

Nothing perverse here. A reasonable treatment of an uncontroversial matter. In other words, not a case of systematic injustice.

But consider the systemic effects of the rule making interest payments deductible but dividends not. First is evidence for the truism that we get more of what is subsidized:

The tax treatment of debt against equity has consistently given companies incentives to finance themselves as much as possible through debt and as little as possible through equity. To state the position in the simplest terms: 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.

While certainly the case, capitalization via debt rather than equity isn't systemically unjust, is it? A mere bias, eh? Consider McIlroy again:

The ability to use leverage to generate outsized returns for a small number of investors at the expense of other stakeholders has seen the number of businesses owned by private equity firms sharply increase since 2008.

But there's more to raise the level of concern about systemic injustice:

The result is that large businesses have become projects in financial engineering rather than enterprises committed to efficiently delivering the goods and services we need today and investing in developing the goods and services we will need tomorrow.

Seriously? Yes:

Debt ... places the vast majority of the risk on the borrower, with the lender (particularly if they hold security) with many more options if the borrower cannot repay the loan on time or at all. Debt creates fragility. The fixed repayments mean companies focus on surviving from day to day rather than planning for the long term. Debt, unlike equity, amplifies the effects of economic downturns. (Emphasis added.)

Is this conclusion warranted? And even if it is, is it systemically unjust? In 2008 I concluded that in 1841[!] the US Congress realized that that some creditors were more equal than others, and that the newly enacted Bankruptcy Act should recognize this state of affairs. In The Missing Piece of the Puzzle: Perspectives on the Wage Priority in Bankruptcy I concluded that

When one remembers that the evangelical commercial moralists spoke to the ethical duties of creditors as well as debtors, it is reasonable to conclude that the wage priority also grew out of similar sympathies. Just as debtors had a moral obligation to pay, so creditors had a moral obligation to extend mercy. The former had long received legal sanction; the latter was about to find its way into the law as well. Even the epithet attached to the 1841 Act by its opponents--"Jubilee of the Bankrupts"--pays homage to the biblical perspective in which the new law was considered. If the 1841 Act as a whole was perceived in terms of the release laws recorded in Leviticus 25, it is likely that a biblically literate population saw the wage priority in terms of passages such as Leviticus 19:13 Deuteronomy 24:15 and James 5:4, each of which clearly enjoined the prompt payment of wages. Other than payment of vows made to God, no specific financial obligation received such frequent biblical mention as the duty to pay wages to workers.

Recognition of a priority of interests among creditors does not entail an equality of treatment of interest and dividends for income tax purposes. Mere bias is not necessarily unjust. Yet, it suggests that we should take into account the real-world effects of tax policy, and that those effects can be systemically unjust. And in the case of deductible interest, sophisticated lenders and corporate managers can allocate risk from themselves to other creditors and shareholders. In other words, gains are captured while losses are shifted without the consent of the (potential) losers. In other words, systemic bias may produce systematic injustice.

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*Of course, we can have systematic injustice where the goal of a system--such as legislation mandating the return of fugitive slaves--is unjust. We should expect that systematic injustice will produce systemic injustice.