Latin American Capital Markets

98 VALERIANO F. GARCIA AND LUIS ALBERTO GIORGIOThe literature has come to the tentative conclusion that banking credit andequity finance are complementary. From the point of view of the business firm, theModigliani-Miller theorem asserts that, under somewhat restrictive assumptions, thefirm is indifferent between financing with debt or with equity (Modigliani and Miller1958).The firm may use both to diversify its source of funding. However; in Latin America,most business enterprises use internal savings and debt, mainly borrowing frombanks, as the means of financing. We argue that this behavior is mainly the result of incentivesderived from government-imposed distortions through tax schemes, which isalso the case regarding the behavior of the savings-surplus economic units, whosechoice is equally biased by distortions favoring deposits over equity as financial assets.Furthermore, there are other matters, not directly related to government intervention,that favor the development of the banking sector vis-a-vis the stock marketFor example, although they have lower transaction costs, equity markets requiremore sophisticated investors than debt markets do. In the financial system, the depositordoes not have to choose a portfolio. In the equity market, the saver has tomake a portfolio choice. In the banking system, deposits are not tied to a specific asset;they are tied to a portfolio chosen by the bank managers. Banks are true intermediariesbecause they make decisions on the portfolio without consulting the clients.Tax DistortionsEmerging economies have characterized themselves by low rates of internal savingsand cyclical, severe constraints on access to international financing. In addition, tax regulationshave distorted financing incentives, encouraging debt taking and debt providing.Government tax distortions against equity are generally strong on both the demandfor and supply of funding.From the point of view of the firm seeking funds (debt taking), the cost ofdebt financing (interest) is indeed considered a cost by the fiscal authorities. If thesame firm uses equity markets, it has to pay a return on the new capital, which willnot be considered a cost. From the point of view of the surplus economic units providingfunds, income tax schemes in emerging markets discriminate against capitalgains from equity holding, compared with the benefits of deposits in the financial system.Indeed, when the developed world had the same income per capita as today'semerging economies, its marginal income tax rates were lower than the rates thatnow appear in Latin American and Caribbean countries. It is common for emergingeconomies to tax corporations at a rate of about one-third of their income.Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub