Approach offers a win-win solution for all parties
CAMBRIDGE, Mass., April 14, 2020 – As many American businesses struggle to survive the current pandemic, it’s critical to help the economy return to normal when the time comes. A new paper by MIT Sloan School of Management Prof. and Harvard Business School Prof. Robin Greenwood suggests an approach to help the supply side of the economy “snap back” in the second phase of the crisis. The key is creating a master agreement that provides a win-win solution for all parties.
“The essence of this solution is that the federal government provides a master agreement that will reduce expensive haggling over debts, provide a floor on repayment, and take advantage of the government’s unique position as a shareholder in all American corporations – from corporate taxes – to fund the policy,” says Thesmar.
In their proposal, the government would offer a simple master agreement for modifying rental contracts during the lockdown and for the two months following its end. Landlords would forgive 100% of the rent during that time for contracts signed before March 1, 2020. At the end of the fiscal year they can claim a tax credit equal to 30% of the forgiven rent. Rents received during the grace period would be subject to a surtax.
“The key point of this master agreement is that it’s a simple take-it-or-leave-it offer. It avoids endless haggling and bargaining over the specifics of the situation, which vary from business to business,” they write. “It is a simple value proposition from which both business partners can benefit.”
Thesmar notes that many states and local governments have offered moratoria on debt payments, but that a few months from now, there will still be debts to resolve. “While many businesses have stopped paying the rent – and have been urged to do so by their governments – we need to start thinking now about how these claims are going to be resolved when America reopens.”
The cost to the government would be 30% of the forgiven rents during the grace period, with 70% of the cost paid by the landlord. The landlord is incentivized to accept the deal if the benefits of the modification, including the tax credit, are worth at least the post-tax value of rents until the end of the grace period.
For example, assuming a 40% tax rate on rents, and a 10% surtax on rental income, the landlord would likely want to sign the agreement if the benefit of the modification is larger than 20% of the rent.
The government also benefits from this proposal. The authors explain, “The government receives tax payments on the additional business income generated by avoiding debt overhang. It bridges the bargaining gap and effectively acts as an intermediary to transform the fixed obligation into equity in the business. The government is a natural long-term equity investor in all businesses, and therefore an automatic residual claimholder in case of business recovery.”
They point out that the additional tax receipts for the government are potentially large, as corporate finance studies estimate costs of financial distress to be as high as 20% of enterprise value. With capital share of value added of about 30% and an average capital income tax rate of 20%, the additional income for the government could be as high as 1.2% of value added of targeted industries.
The cost, they note, is of the same order of magnitude. “With commercial leases being about 3% of GDP, the intervention could cost as much as .9% of GDP if the take up is 100% and the grace period one-year long. If the time period is shorter and the policy targeted at small businesses, the real cost should be a fraction of that.”
Thesmar adds, “This proposal is a hybrid approach of some prior suggestions. It attempts to nudge capital providers to take a haircut on their claims, while still keeping a small but meaningful role for the government. In this approach, everyone benefits, and we help the economy snap back to normal operations.”
Thesmar and Greenwood are coauthors of “Sharing the economic pain of the coronavirus.”
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