Opinion

Felix Salmon

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.

Comments
8 comments so far | RSS Comments RSS

… 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. …

What’s the point of banning interest deductions if you are going to allow transparent evasions like this? This is like the contortions some Moslems go through to avoid acknowledging they are paying interst.

 

“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.”

How ’bout we stop double-taxing dividends then? That also solves the “share appreciation at any cost” management tactics institutional investors demand. Cash dividends are just as good, as long as it’s not double-taxed.

Posted by Brock | Report as abusive
 

What exactly is wrong about debt financing? In some cases, it doesn’t make sense, but some business models only work with debt financing. If your primary objection is that it lets private equity firms avoid taxes, there are other solutions, mainly limiting the amount of leverage. Private equity firms do show a profit, but it is often delayed (there’s a concept alien to most Americans, delayed gratification), and the debt allows it be treated as capital gains, which is taxed at a lower rate. That is the problem, preferential tax treatment for speculative bets which only shift assets on paper while creating no new value, not allowing interest expense to be deducted.

A lease is not always an option (the property owner may want to sell, or the would-be tenant may want total control of the property – as a renter, you should be able to understand that), and besides, since the rent payments include landlord profits on top of all the costs that get passed on to tenants, rent payments will usually result in a larger deduction than interest and depreciation (now there’s a deduction you should eliminate – depreciation for assets that actually appreciate).

Eliminating the deduction for legitimate interest expense would greatly reduce business expansion – not everybody wants the risk of equity participation, whereas responsible lending (not practiced a whole lot during much of this decade) with collateral greatly reduces risk. If you got rid of the interest deduction, incentives for savings would also be eliminated, as you would force a big part of the population to become investors, most of which are not really qualified for the job.

The main problem with debt is that the government has guaranteed way too much of it, with too few restrictions, and too little oversight. We should try to fix that mess before opening another can of worms.

 

… Well, yes, if you taxed interest payments you’d be taxing something other than income. That’s the whole point. …

So call it an interest tax or mortgage recording tax or something but don’t mangle the income tax by including things that aren’t income.

Of course that would make it harder to say things like this:

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.

 

Felix: Do not get involved in the details. It is possible to make interests non deductable, but it would be a fundamental change that will lead to a heap of other changes in order to make it a coherent set of rules for taxation. Believe me – you do not want to get involved in that.

Many countries have non deductable expences based on “don’t like it”. Several countries do not allow deduction of alcohol expences. Interest on toxic debt could be made non deductable based on the same logic (don’t like it).

Posted by Gaute | Report as abusive
 

If you have to distinguish an interest expense from a legitimate business expense, you have already given up the game. Interest expenses are legitimate business expenses and it is inconceivable how one could distinguish them. Secured vs unsecured? Is the conversion of debt to preferred stock so useful? What does it buy us?

Posted by Lord | Report as abusive
 

Why would we want to regulate leverage/lending standards via the tax code? Wouldn’t it be easier to regulate them by, oh, I don’t know, letting some idiots go bankrupt once in a while? What’s the problem is creditor and debtor want to take on the risk of dealing with one another and from time to time one of them loses? There’s no reason for the tax system to be involved other than in taxing the income that results to both the corporation and the lender.

Posted by najdorf | Report as abusive
 

‘implementing this tax “would make companies that do use debt finance much more risky”.’
NO
The firms are already risky, it would serve it less attractive to be so risky.

Posted by Jim Caserta | Report as abusive
 

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