The problems with debt-based financing – personnel costs as a key factor
An efficient flow of capital to companies is the main pillar holding up the real economy. Many countries, Austria included, offer tax breaks that indirectly subsidize corporate borrowing, because interests paid to creditors count as deductibles and reduce a company’s tax burden. A recent study by WU Professor Josef Zechner shows how the government’s indirect subsidization of corporate debt leads to higher risks for employees.
Financing a company with borrowed capital appears to be lucrative in many countries. Austria is one of the countries that offer tax incentives which favor debt over internal financing, particularly by allowing interest payments to be deducted from companies’ taxable income. In Austria, the tax deductions granted to a company that covers 60% of its financing needs with borrowed capital correspond to roughly 15% of the company’s total value. But debt-based financing also has many disadvantages. In several of his studies, WU Professor Josef Zechner from the Institute for Finance, Banking and Insurance has investigated the factors that are relevant when it comes to selecting an appropriate financing structure for companies. His research shows that even though personnel costs are one of the key factors for deciding on the right financing structures, they often tend to be overlooked.
The higher the debts, the higher the risks
The more debt a company accumulates, the higher its risk of slipping into bankruptcy. “A high bankruptcy risk has a number of consequences: Particularly in highly specialized industries, customers will lose trust in the company. There will also be a drop in investments when creditors become reluctant to provide fresh capital for the company due to the high bankruptcy risk,” Professor Zechner points out. “One key factor that often doesn’t receive enough attention are personnel costs. Particularly in specialized industries, employees have to expect financial losses in the event of their company going bankrupt.” If they still want be able to hire qualified employees, companies with substantial debts have to offer them higher salaries right from the start to balance out these risks. Model simulations show that an increase in a company’s debt ratio from 30% to 60% would cause its salary costs to rise by around 14%.
Misguided tax incentives
The results of Josef Zechner’s empirical studies, conducted on the basis of data from international power generation companies, confirm his theoretical findings. Many enterprises, particularly in specialized industries, are seeking to reduce competitive risks for employees and are increasingly focusing on internal financing to keep costs down. “It’s hard to understand why the government is still subsidizing debt-based financing. In many cases, debt-based financing also has disadvantages for employees, for instance a higher risk of losing their jobs and income in the event that their employer goes bankrupt. In specialized industries, this means that employers have to spend more money on salaries,” Professor Zechner explains.