A principal cause of the decline in competitiveness of America's industry is the high cost of capital in the United States. In fact, American firms must pay about three times as much for capital as do their Japanese competitors -- a differential that places U.S. industry at a tremendous disadvantage.
In steel, for example, had U.S. companies enjoyed the same cost of capital as their Japanese counterparts, capital formation in this key sector could have been increased by an average of $3 billion a year over the past 10 years. This represents a doubling of actual investment -- an increase that, if properly invested, could have had a dramatic effect on the current and prospective viability of the nation's steel industry.
Although the reasons behind our expensive capital are complex and diverse, a key factor is the heavy reliance of American companies on equity rather than debt. The average debt-to-equity ratio for U.S. industrial firms is only 1 to 3. By comparison, Japanese firms in industries targeted for development have average debt-to-equity ratios of 3 to 1, or about nine times that found in the United States. While part of this difference reflects a preference on the part of U.S. managers for avoiding the financial risks of debt, fundamental differences in the tax codes and in the structure of financial institutions in the United States and Japan are more critical factors.
American companies tend to prefer equity to debt because the risks are lower. When a company incurs debt, management takes on a fixed obligation to make payments to lenders every year. With equity, management can defer or eliminate dividends if the company has a bad year. Risk isn't eliminated with equity, however; it is shifted to the investor, who is not assured of a return on his investment. Such an investment naturally requires a higher return to compensate for the additional risk. Hence, equity is more costly than debt. On top of this, however, our tax code further increases the effective cost of equity through double taxation -- once at the corporate level and again at the personal level. Thus, to offer even the same after-tax returns on debt, the before-tax rate of return on equity must be much higher to accommodate the additional taxes.
Viewed from the American perspective, the high debt-to-equity ratios that prevail in Japan would seem to be dangerous and imprudent. On closer examination, one finds that much of what is called debt in Japan is actually equity that has been made free of double taxation. Under Japan's financial structure, lending institutions often hold significant equity positions in the companies to which they grant loans. Because the banks can expect to realize added gains from the appreciation of stock values, they are more willing to be flexible on loan repayment.
The long-term implications of America's chronic disadvantage in the cost of capital are frightening. We already have witnessed the decline of some of our most basic industries. America's high-technology sector is likely to become the next victim of expensive capital. Long-term research projects cannot be justified when the cost of funds for such investment is too high. American managers have been criticized in recent years for their tendency to focus on short-term objectives. In fact, such preferences simply reflect a rational response to the need for quicker payback on costly capital. Japan's far lower cost of capital relative to the United States' justifies its managers investing 2 1/2 times as much money in a project requiring five years of development. For a project expected to pay off after only 10 years, the foreign advantage is even wider: Five times as much capital can be invested in Japan as in the United States.
Clearly, the sharp increase in the U.S. cost of capital over the last two decades has slowed investment in productive assets, reduced productivity gains and curtailed the growth in our standard of living. Worst of all, it has been a major factor in the export of U.S. jobs to countries such as Japan that enjoy much lower capital costs.
There are no simple solutions to this highly complex problem. We cannot restructure our entire economy, nor can we mandate new relationships between investors and corporations. But there are three basic approaches that should lower the cost of capital: Lower the demand for credit. There is no more urgent priority for government policy makers than reducing the federal deficit. Not only would this lower interest rates, but it also would be likely to ignite the stock market, making it easier and less expensive for companies to issue equity. The stock market boom of 1982-83 had this effect. Increase the supply of credit. We need to increase our rate of savings, which is less than half that in Japan. Our current tax policy discourages savings by taxing individuals on the interest they earn and giving them deductions on the interest they pay. We could eliminate the tax deduction for interest paid on consumer debt and use the increased tax revenue to reduce the tax rate on interest earned. Change the risk environment. Reductions in the capital gains tax over the last eight years have been very effective in encouraging greater risk-taking by investors by increasing their after-tax return on investment. Because the deficit is so large right now, further reductions are not possible. But we can look at other ways to encourage a more efficient sharing of risk by investors. For instance, to encourage investors to take risks, we could reduce capital-gains-tax rates for new preferred equity issues or allow investors to defer tax liability for investments in new ventures until such ventures became profitable. To encourage companies to raise new equity, we could allow them to deduct dividends paid on new stock issues so long as these new funds were used for productive investment and not acquisitions or repurchase of their existing stock. Such changes would cost the Treasury little but would have a major impact on the cost of capital for new investments.
Over the long run, U.S. industry cannot continue to compete on the unequal terms now prevailing. If we turn to protectionism as the answer to industrial competitiveness, we only will create barriers to international trade that will be self-defeating. To be competitive, our government, as well as our industry, must avoid taking the short-term view. Industry must make long-term investments in innovation and productivity, and the government must create an economic environment that encourages companies to make such investments.