Tuesday, October 17, 2006

A case for income trusts

When BCE joined Telus in its decision to convert to income trusts, people became skeptical, including Marc Lee over at the REP blog. Marc invited his readers come up with reasons why income trusts might have economic benefits. I couldn't resist taking the bait.

In defence of income trusts:

1. Income trusts allow firms to maximize profits because they encourage the convergence of objectives held by management and ownership. In other words, income trusts increase the likelihood that management will act as profit maximizers rather than risk averse agents.
This point hadn't occurred to me until I came across it in The Globe and Mail.

What started as a way for small companies to cut their tax bills has become something else — a tool for shareholders to reclaim some of the discretion that once belonged almost exclusively to CEOs and directors, and at the same time address one of their deepest concerns: a lack of faith in corporate executives to spend their excess cash wisely.
Trust conversions, in other words, may come to represent one of the biggest power shifts between investors and management that Canada has witnessed in a generation.

2. This point is related to the last. As management begins to make profit-maximizing decisions, the nation as a whole should benefit. Productivity and returns should be expected to increase over time.

3. Detractors of income trusts argue that income trusts will erode the tax base. Perhaps this concern is inflated, considering that the majority of provinces are currently running a surplus.
4. Income trusts have offered an attractive payout to investors and also to the securities industry. Canadians investing in income trusts are bringing in a nice profit. Large firms simply are not the only ones profiting.

5. Evidence from The Bank of Canada shows that income trusts may enhance financial market completeness "by providing diversification benefits to investors and a source of financing to firms that might not otherwise have had access to markets.” Although the BoC suggests that income trusts are not without faults (eg. liability and lack of transparency), their report implies that these problems can be corrected.
The bottom line is that Canadian firms are feeling over-taxed and income trusts are the upshot of this. To be honest, I still haven't completely formed an opinion; however, I don't think the benefits I've cited are really so minor. I'm not ready to write off income trusts just yet.


Erin Weir said...

True Dough, congratulations on the witty name and interesting blog.

I am no expert on this subject, but in response to your first point, the trust structure forces managers to focus on making payments to investors every month and hence on short-term profitability. However, this need to generate enough cash every month may make them more risk-averse, perhaps to the detriment of growth and long-term profitability.

Marc said...

Thanks True Dough for some interesting fodder on income trusts. It will be interesting to see if your point one plays out in practice -- it would be nice if income trusts were able to reign in excessive executive salaries, though I am skeptical that this will actually happen.

I think the issue around taxation could readily be solved if there was the political will to do something about it.

But the most compelling point I have seen is that conversion to a trust creates incentives that may lead to less investment, and therefore lower productivity in the future. This is just speculation not empirical evidence but if true does indeed have profound negative macro impacts that would dwarf any marginal efficiency gains suggested above.

It may be the case that for some forms of activity income trusts are an appropriate governance structure -- don't get me wrong. But if the driving force behind conversions is indeed tax avoidance, facillitated by the economic incentives of corporate executives, bankers and shareholders, then this asymmetrical treatment may be leading companies to convert to income trusts who would not be doing so were the playing field level.

I'd be interested in any empirical research on the investment implications of income trusts before I come down with a final decision.

true dough said...

Thank you Erin and Marc for the comments.
I agree that this is certainly an under-researched area. I look forward to seeing more on this.
Marc, you say: "I think the issue around taxation could readily be solved if there was the political will to do something about it."
As you imply, at this point it seems like the government is too timid to cut corporate taxes, and perhaps doesn't mind so much that firms have found a way to cut taxes themselves.