Surely it would make sense to distinguish between interest paid in the ordinary course of trade (eg by a bank to depositors)and interest paid on long term debt. I suggest the former should continue be tax deductible.

you really need to think through your assertion that eliminating the tax deductibility of interest “would do wonders for the US fisc(ally)”.

What you are talking about is an increase in after tax interest rates of nearly 50%. As an example, a loan at 7% interest has an after tax cost of 4.5% (assuming a 35% marginal rate). Eliminating the deductibility increases the after tax cost from 4.5% to 7%, or up 55%.

Do we really need to increase the cost of capital to business by over 50%? Would that do wonders for the US? Quite the opposite.

There are several problems with prohibiting companies from deducting interest payments from taxable income, both theoretical and practical. To list a few, I think that you’ve conveniently overlooked:

(1) This proposal destroys the economics of being a financial intermediary that lends money and in turn pays interest on borrowed funds (whether those funds are deposits or bonds), i.e., a bank. Go through the math – the traditional business of a bank is to earn a spread based on the interest earned on loans less the interest paid on borrowings (whether deposits or wholesale funding). This proposal suddenly prohibits deducting the latter expense, which means that a bank has to increase the interest rates that it charges to maintain profitability. The underlying problem is that the same income is being taxed 3 times – once as income for the company that borrows from the bank (with no deduction for interest expense), once as income for the bank (again no deduction for interest expense), and a 3rd time as interest income for the person who is a depositor/bondholder of the bank. This treatment also creates a huge incentive for the ultimate borrower – a company – to fund directly in the bond market and limit the situation to double taxation rather than triple taxation. This proposal is equivalent to a big hike in interest rates because it makes credit dramatically more expensive, and the biggest losers would be companies that are too small to access the bond market directly.

(2) If this proposal were phased in immediately, particularly in the current earnings environment, there would clearly be companies that immediately become unable to service their debt. You might claim not to care, but it is reasonable that companies have made cash flow projections based on the tax deductibility of interest expense. To suddenly change such an important provision of the tax code is dramatically unfair. Think of commercial real estate as an example. Have there been some speculative excesses – of course. That said, suppose that an owner of an office building or retail center has done everything in a “correct” or “prudent” manner. The owner has tenants with long-term leases and, based on that certainty, funded a project with 70% or 80% debt. The economics of the project suddenly don’t work solely because a change in the tax code means that interest cannot be deducted.

(3) The complexity created by this proposal could also be a dramatic problem. I would imagine that companies and lenders would find alternate arrangements to reclassify a loan and “interest” as something else. For example, a company might sell its inventory of raw materials to a lender (thus getting cash) and agree to buy back the raw materials over time at a mark-up, turning non-deductible interest into a tax-deductible expense for cost of sales. Though I am far from an expert on Islamic finance, I would expect techniques from this sector to be used across the U.S. economy, since my view is that the goal of much of Islamic finance is to refashion “debt” and “interest” as an economically equivalent relationship with a different name. Attempting to regulate these types of transactions
would be extremely complex.

Felix, I find much of you write to be very interesting, but this idea is not well thought-out. A better proposal – allow corporations to deduct dividend payments and then also tax such payments as ordinary income for the recipients. At that point, we’re treating debt and equity the same, without putting the economy through a wrenching transformation to do it.

I am in fact in favor of no taxes on dividends, since the highly leveraged perpetual growth model favored by most corporations leads executives to do stupid, short-term things. It also leads to the illusion that the only “good” corporation is one that’s growing rapidly.

However, for this to really make sense, corporations would have to be subject to some sort of reasonable flat tax, from which there were no deductibles. Since lobbying Congress for special treatment is beloved by executives and politicians both, I am not holding my breath.

What we need now is capital market governance of randomness—a blueprint for fundamental change to the legacy, one-size-fits-all deterministic governance regime. I have created such a plan, describing how to do the right things for governance effectiveness and how to do things right for governance efficiency.

The legacy governance system for the US capital market is in disrepair. To achieve real regulatory reform, policymakers have to move beyond form to substantive issues. Unless experimentations to the legacy, one-size-fits-all deterministic regime take place, our capital market will be caught in a recursive loop of errors of commission (boom-bust bubble inefficiencies) and errors of omission (externality market inefficiencies). Such inefficiencies will eventually render our source of economic wealth ineffective.

If this happens, we’re all screwed.

Stephen A. Boyko

803-644-7295
n2keco@bellsouth.net

Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System”
http://www.w-apublishing.com (http://www.w-apublishing.com/Shop/BookD etail.aspx?ID=D6575146-0B97-40A1-BFF7-1C D340424361)

Book Review: Brenda Jubin, Ph.D Thursday, October 8, 2009
http://readingthemarkets.blogspot.com/se arch?updated-max=2009-10-15T06%3A23%3A00 -04%3A00&max-results=7
Boyko, We’re All Screwed!

We should end the double-taxation on equity, not double-tax debt too.