Comments on: What are the arguments for privileging debt? A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: Sandrew Tue, 17 Nov 2009 16:51:00 +0000 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.

By: HAL Tue, 17 Nov 2009 14:05:33 +0000 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.

By: Robert Cunningham Tue, 17 Nov 2009 01:28:54 +0000 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.

By: Sandrew Mon, 16 Nov 2009 21:55:34 +0000 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)?

By: Lilguy Mon, 16 Nov 2009 16:36:19 +0000 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.

By: Brock Mon, 16 Nov 2009 14:41:39 +0000 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?

By: Kyle Mon, 16 Nov 2009 14:38:14 +0000 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.

By: Tim Coldwell Mon, 16 Nov 2009 12:49:45 +0000 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?

By: Andrew Mon, 16 Nov 2009 12:37:44 +0000 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. 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.

By: Bob Pendleton Mon, 16 Nov 2009 11:56:00 +0000 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.