Reasons not to tax interest payments

By Felix Salmon
November 16, 2009

Philosophically speaking, why don’t we tax corporate interest payments? (Practically speaking, the answer is that it’s politically impossible.) So far, the answers have fallen into three broad categories.

The first one feels like a category error to me, and basically says “the corporate income tax is a tax on income, and a tax on interest payments isn’t a tax on income, so you can’t expand corporate income taxes to include a tax on interest payments”. Well, yes, if you taxed interest payments you’d be taxing something other than income. That’s the whole point. Private equity shops love to load so much debt service onto their portfolio companies that they never make a profit, and therefore never have to pay taxes. This is not something we want to incentivize. There are lots of non-income taxes in the US; this would just be another.

The second two answers are better. Kyle says that it would be almost impossible to build such a law without loopholes: “there are lots of ways to create debt like exposure that appear to be expenses”. And Megan McArdle writes that debt really is a legitimate business expense for certain companies:

Heavy industrial companies need more capital to make new investments, and it can make good sense to match the duration of the financing to the expected life of the asset. That’s accomplished by borrowing money, not floating a new stock issue or trying to accumulate enough retained earnings to keep up with your competitors.

Interestingly, these two objections seem to cancel each other out somewhat. If an industrial company wanted to finance the purchase of a major asset, it could simply sign a long-term lease instead, turning a taxable interest expense into a legitimate business expense. And it would be quite easy to say that leasing companies had to be part of federally-regulated bank holding companies (which would be exempt from this tax), and couldn’t be part of the same corporate ownership structure as the companies they were leasing to.

I agree with Megan that implementing this tax “would make companies that do use debt finance much more risky”. That’s the whole point. We want to move away from over-reliance on debt finance, and towards a world where equity finance becomes much more common and much more boring. If investors want to leverage corporate profits with debt they can do so themselves, by buying stock on margin. But let’s not implement the leverage at the corporate level, where it’s imposed on even the most risk-averse equity investor.

Update: Steve Waldman adds that what we’re talking about is eliminating a tax deduction, rather than imposing a new tax. A useful thing to bear in mind.

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