Look at Macy's: U.S. tax code encourages companies to rack up huge debt

A heavy debt burden can also come with severe consequences, some more obvious than others.

It makes companies far more vulnerable to shocks -- for instance, a severe recession. It also can be more expensive than other ways of raising money because failing to return the loan, or even missing a few repayments, can force a company into a costly bankruptcy.

In the wake of the financial crash, corporations, including Macy's, have been urgently paying down debt and hoarding cash. Non-financial companies have saved up to $1.8 trillion in cash, about one-quarter more than when the recession began in early 2007. But without correcting the imbalance in the tax code, according to a wide range of tax analysts, the government will continue to encourage new cycles of debt-fueled booms and busts.

So far, there has been no effort by the federal government to curb the role of the tax code in inflating the economy's debt levels. A bipartisan bill in the Senate that would do so has stalled. The financial regulatory overhaul approved by Congress last month does not address the matter.

Macy's executives acknowledged that the company became overly indebted in the late 1980s. They said more recent borrowing levels have been manageable, even after the firm's debt rose to $10 billion as part of the mammoth acquisition of its competitor May Department Stores five years ago.

But several retailing analysts said that deal left Macy's on shaky ground when the recession began in late 2007. After the takeover, Macy's "had big slugs of debt the next couple of years," said Ken Stumphauzer, an analyst at Stern Agee. "They will be able to refinance now because credit markets have opened up . . . but it was scary for a little bit."

Debt no longer taboo

For decades, the memory of the Great Depression, with its devastating toll of defaults and bankruptcies, made executives wary of piling up debt anew. High credit ratings from Moody's and Standard & Poor's were viewed as a badge of success.

That changed radically in the 1980s. The rise of the junk-bond market offered companies the chance to borrow enormous sums of money, often for taking over other firms, in return for paying exceptionally high interest rates.

Federated Department Stores was a poster child of this era. Hailed as one of the most stable companies in the nation in the early 1980s, Federated was bought out by Canadian real estate magnate Robert Campeau in 1988 for $6.6 billion. Campeau borrowed most of that money and then put it on the company to pay it back. After the buyout, for every dollar in cash that Federated held, it had $32 in high-interest loans.

From Campeau's point of view, all this leverage came with a big benefit, compliments of the federal government. Under the tax code, the company he took over could deduct its high interest payments from the taxes it paid on its income.

If Campeau had used the borrowed money to build, say, a new warehouse, rather than take over an entire company, he could have won yet another kind of tax benefit. Many firms use borrowed money to pay for buildings and equipment and are entitled to a second tax deduction under an accounting principle known as "accelerated depreciation." As the value of buildings or equipment declines over time, a company can use this depreciation to reduce its tax liability.

The combined impact of those two deductions can be tremendous, according to the Congressional Budget Office. Together, they can free a company from paying tax on any income produced by projects financed with debt. But that's not all. The combined deduction can be so large that a company may also be able to apply some of it to its other income, reducing the overall tax bill even further.