Debt taxation datapoint of the day

By Felix Salmon
February 8, 2010
banging on for a while that one key cause of the crisis was the tax-deductibility of interest payments, and the incentive that gives companies to finance themselves with dangerous debt rather than safer equity. But I didn't realize it was this bad. Pete Davis finds this table in an October 2005 CBO report, at the height of the debt bubble:

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I’ve been banging on for a while that one key cause of the crisis was the tax-deductibility of interest payments, and the incentive that allows companies to finance themselves with dangerous debt rather than safer equity. But I didn’t realize it was this bad. Pete Davis finds this table in an October 2005 CBO report, at the height of the debt bubble:

taxrates.jpg

It really is as bad as that: companies financing themselves with equity pay an effective tax rate of 36%, while companies choosing debt pay a negative tax rate of 6.4%. How is that even possible? The CBO report explains:

The effective tax rate on debt-financed corporate capital income is negative in part because accelerated depreciation and interest payments generate tax deductions in excess of taxable income, which leads to corporate tax refunds. Taxes paid by savers on interest received do not entirely offset those refunds; again, much of that interest income is received in various accounts in which it is not taxed.

In other words, companies lever themselves up so much that their interest payments are larger than their income, and so they get tax refunds and pay no corporate income tax. This can’t be healthy. And, sadly, it’s not going to change, either, Paul Volcker notwithstanding.

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Comments
5 comments so far

Though the idea makes sense to me, I’m worried about starting to disallow deductions for something that is by any measure a ordinary/necessary business expense.

I’m curious about this bit though: “much of that interest income is received in various accounts in which it is not taxed.” Seems to me that somewhere somebody has to be making money on interest – and that should be taxed. If it’s not – perhaps subjecting those accounts to taxation is a better solution than the one proposed here.

Also – a related solution: how about ending the double tax on dividends to make equity financing attractive?

Posted by CGG | Report as abusive

CGG: it’s not quite as radical as you seem to suggest if you transition to the system; if you say “debt issued after 2010 cannot have its interest deducted”, or even allow a little bit of rolling over of maturing debt, you can get to a new equilibrium (“ordinary/necessary”) without really punishing anyone for previous decisions; companies can retain earnings and issue more equity. You can lower the tax rates at the same time if you like; some industries that are more debt-heavy right now would see their taxes go up, but if all of your competitors’ costs are going up, you can pass that along to your customers. Note that this kind of phase out would remove the tax incentive on short-term debt the soonest; longer-term debt isn’t quite as big a systemic risk (though it certainly contributes).

Posted by dWj | Report as abusive

A 12/20/07 U.S. Department of the Treasury Office of Tax Policy report shows that the marginal effective tax rates on debt v. equity financed investments did not change much by 2007.

See pages 81-84 of the actual report.

http://www.treas.gov/press/releases/repo rts/hp749_approachesstudy.pdf

Posted by david3 | Report as abusive

The debt tax shield has always struck me as addlepated, both on corporate and personal (mortgage interest) levels. Then again, I am neither a levered corporation nor a mortgageholder. I am sure I would understand the appeal just as soon as I started getting my sweet government subsidies.

How I pine for some sweet government subsidies of my very own.

Posted by wcw | Report as abusive

Does this analysis includes the fact that debt financing fees are amortizable whereas equity financing fees are neither amortizable or deductible. And, of course, equity financing fees are way higher as a % of capital raised.

Posted by agc2 | Report as abusive
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