What are the arguments for privileging debt?

By Felix Salmon
November 16, 2009
Jim Surowiecki for unambiguously adding his voice to those who would abolish the tax-deductibility of interest payments:

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Three cheers to Jim Surowiecki for unambiguously adding his voice to those who would abolish the tax-deductibility of interest payments:

Debt didn’t get dangerously out of scale because the system was broken. It got out of scale, in part, because the system worked…

As much as possible, the tax system should be neutral between debt and equity, and between housing and other investments. It’s not, and, worse still, as we’ve seen in the past couple of years, debt magnifies risk: if companies or individuals rely on large amounts of leverage, it’s much easier for bad decisions to lead to insolvency, with significant ripple effects in the wider economy. A debt-ridden economy is inherently more fragile and more volatile.

The weird thing for me is that when I start banging this particular drum, I always get exactly the same answer: “yes, great idea, not gonna happen”. But is there any intellectual justification whatsoever for making corporate interest payments tax-deductible? I can see an argument for a carve-out for highly-regulated banks, since their entire business is based on making profits from the spread between the rate at which they lend and the rate at which they borrow. But banks aside, why should companies pay lots of tax on dividends, and no tax at all on bond coupons?

In a way it’s depressing: if this were a real debate and Paul Volcker had a remote chance of making interest taxation happen, then surely there would be no shortage of academics and corporate lobbyists making the case for keeping the status quo. The fact that they’re not even bothering is all the evidence we need that this isn’t even going to reach trial-balloon status, let alone get signed into law.

But still, the question remains: if they were to start taking this seriously, what arguments would they use? After all, as Surowiecki notes, the likes of Brazil and Belgium seem to do perfectly well without giving debt this artificial advantage.

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Comments
12 comments so far

The massive distortions and wealth transfers of suddenly taxing something that was once tax free is a defense of maintaining the tax exemption of interest but certainly not an argument against lowering taxes on profits.

… But is there any intellectual justification whatsoever for making corporate interest payments tax-deductible? …

If you intend to tax profits then debt clearly should be deductible and dividends clearly shouldn’t be. Which is why it is done that way.

There is a double tax issue with dividends which could be solved by making them tax free to the recipient.

One argument con is that mortgage interest deductibility supports the great American dream of homeownership (and the real estate profession). And that’s why “it ain’t gonna happen.”

Yet the arguments pro are strong – increase tax revenues, take a swipe at the debt monster, bring banks down to size, lower the debt-to-equity ratio.

Posted by Bob Pendleton | Report as abusive

As pointed out in the comment above, one main issue is a conceptual one, and tax is a highly conceptual field. Income tax is a tax on profits, and once you start taxing interest you increase the odds of levying a profits-based tax on unprofitable businesses.

There are also pretty complex knock-on effects to making interest completely non-deductible that would need to be comprehensively addressed (in both domestic and international terms, including comprehensively updating treaties that only get renewed on a decades-long timetable). As far as policy/regulatory coordination problems go, this would leave climate change policy far behind, with any leading country being at a truly unacceptable commercial disadvantage for many years.

However, there’s certainly precedent for treating “excessive” interest as non-deductible, in relation to highly geared (or “thinly capitalised”) companies, and no reason not to crack down on this further.

http://en.wikipedia.org/wiki/Thin_capita lisation

In the US, “earning stripping” rules apply where interest is used to shift profits overseas.

In Australia “thin capitalisation” rules prevent interest deductions where the balance sheet is geared more than 3:1.

In the UK, interest on loans that wouldn’t be made between arm’s length parties is disallowed.

There’s no reason why these rules can’t be made more stringent, and internationally harmonised over time, making debt finance (for non-financials) far more expensive over, say, a 50% or even 30% gearing level.

Posted by Andrew | Report as abusive

Non-deductability of interest costs would hit leverage games that are the essential fuel of Wall Street. However, removing interest deduction on home mortgages many years ago, UK home prices still went into bubble territory. So what does this tell us?

The last time you posted on this topic there was an excellent explanation. The short answer is that there are lots of ways to create debt like exposure that appear to be expenses.

Posted by Kyle | Report as abusive

What are the arguments for double-taxation generally? Both debt interest and dividends are income to someone. They both should be taxed at the personal income level.

Double taxation is distortionary. It discourages capital formation into public corporations (keeping more capital in privately held LPs and LLCs). It also encourages the “share price growth at any costs” mindset on Wall St. that drives ever larger mergers and corporations.

Why are we building a tax system that prefers companies large and inefficient, rather than cash-generating and profitable?

Posted by Brock | Report as abusive

About the only approach that I can think of that might be politically palatable would be to phase in the reduced deduction over ten years–ten percentage points at a time.

This would give companies and people enough time to adjust to their new tax obligations–while they continuously bombard their representatives to stop these deduction reductions.

Posted by Lilguy | Report as abusive

I second Brock’s comment re: double-taxation. To frame the only options as taxing interest versus not is a false choice. We have at least three choices:

1.) The Status Quo – We devise all manner of tax laws to divine the line between income and expense (or dividends and debt service) and what’s “deserving” of being taxed just the once,
2.) Tax Both Corporate Interest and Income – We treat interest like we currently treat income and tax both twice, or
3.) Tax Neither – We can treat income like we currently treat interest and tax them both just once. In other words, ban the corporate income tax and either (a) make up for the shortfall with some other similarly-progressive tax (i.e. wealth tax, higher marginal income tax rates, higher dividend/interest/capital gains taxes, etc.) or (b) not.

Said differently: Is there any intellectual justification whatsoever for taxing corporate income (at the level of the corporation)?

I don’t see why this is so hard. It’s just the symmetry principle: everyone’s income is someone else’s expense and vice versa. Leaving aside the question of taxation at the corporate level, even here the principle applies. Interest paid is an expense for the borrower — and should be deductible — and is income for the lender and should be taxed to him. No different from labor costs…expense to the corp, income to the worker…or…since leasing was mentioned as a substitute…rent as an expense and rental income…as, in the first instance, revenue, with the imputed interest spread in most cases being the taxable amount (it’s equivalent to depreciation and interest expense netted from rent revenue…)…the distinction between leasing in which the interest component of rent is an expense but interest on a loan is not is false.

It’s simply the symmetry of income and expense accounting as it is with every other input.

Posted by Robert Cunningham | Report as abusive

I think what people are missing is the fact that corporations can (generally) choose their capital structure. Debt service is an “expense” that detracts from “profits” only to the extent that corporations choose to issue it. And, as an encouragement for them to do so, the value of the equity grows but is untaxed until sale, and then at a preferential rate. Thus, when an LBO shop delevers and sells one of their companies, they pay about the same amount of taxes as someone making minimum wage at 7-11.

An intellectual justification for taxing corporations? How about the fact that they’re legal fictions created to protect the wealthy from liability. The state is providing a service, and that service is not free. If you want to be taxed at the individual level, create a sole proprietorship or a partnership.

I think this justification for privileging debt in the capital structure is most compelling: debt is a form of slavery that ties workers to the machinery they must operate, and it is very efficient at doing so. Want to quit your job and start a new business? Hope you don’t have a mortgage. Graduate law school but don’t want to work for Exxon or Citibank? Hope you got a scholarship. Did you get your union card at the IAM, fixing airplanes for northwestern? Better make more concessions, these bondholders have to be paid.

I like the view, HAL. Re: The double-taxation of corporate income as a price paid for enjoying limited liability. I retract my prior rhetoric.

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