How to reduce the deductibility of interest payments

February 23, 2012
framework for business tax reform put out yesterday by the White House and Treasury.

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I was literally grinning when I read the framework for business tax reform put out yesterday by the White House and Treasury. Admittedly, it’s not going to get implemented any time soon. But it sets the agenda for any attempt to reduce the corporate income tax rate from 35%. And in doing so it makes an official and extremely strong case for massively reducing the tax deductibility of interest payments.

This is not a new idea, of course: Paul Volcker was pushing it in 2009, and the financial commentariat largely loves it: see Jim Surowiecki, for instance, or Steve Waldman, with a wonderful post from January 2008, before we saw a devastating global example of just how damaging too much leverage can be. And if you’re been reading my blog for a while, the idea certainly won’t be new to you.

But now the government has said, very clearly, that it’s on board — something I’ve never seen before. Remember the CBO report which showed 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%? Well, this latest document does that one better:

The effective corporate marginal tax rate on new equity-financed investment in equipment is 37 percent in the United States. At the same time, the effective marginal tax rate on the same investment made with debt financing is minus 60 percent—a gap of 97 percentage points.

This tax preference for debt financing has important macroeconomic consequences. First and foremost, outsized reliance on debt financing can increase the risk of financial distress and thus raise the likelihood of bankruptcy. Unlike equity financing, which can flexibly absorb corporate losses, debt and the associated contractual covenants require ongoing payments of interest and principal and allow creditors to force a firm into bankruptcy. A solvent firm with limited liquidity that is struggling to make its debt payments may experience losses of customers, suppliers, and employees. It may engage in destructive asset “fire sales” and forgo economically profitable investments. And, in an attempt to avoid bankruptcy, levered firms faced with financial distress may resort to high‐risk negative economic value investments. In the broader context, a large bias towards debt financing in the corporate tax code may lead to greater aggregate leverage and the associated firm‐level and macroeconomic costs of debt financing.

As part of the framework, then, the Obama administration explicitly proposes “reducing the bias toward debt financing”, although it doesn’t say by how much. Dan Primack addresses that question today in a smart post; he reckons that 65% of corporate debt interest should be tax deductible, while allowing companies with less than $20 million in revenues to deduct 100% of their debt interest. (And, presumably, banks, too.)

I think this is a very sensible way to have the debate. The tax code can decree the tax-deductibility of corporate debt interest payments anywhere on the spectrum from 0% (which I would love) to 100% (which we have now). There’s no good philosophical reason why it should be 100%, and there are lots of excellent reasons why it should be lower than that. So let’s have a debate about where it should be, and encourage the 1% to come up with their own ideas. As Dan says, a lot of capitalists in areas like venture capital would love the idea of reducing interest deductibility to pay for lower income tax. So let’s see what the Republicans think, and what the business community thinks, and arrive at some kind of consensus. We’re not going to get the deduction abolished completely. But we can definitely make a big move in the right direction.

Update: In the comments, @realist50 brings out the dual-taxation argument, saying that one person’s interest expense is another person’s taxable income. Which isn’t true: if I borrow money from a corporation which isn’t profitable, then no taxes are paid on my interest payments. And in general, interest income is revenue for the lender, not taxable profit. Besides, all dual-taxation arguments are silly. But in this case they’re particularly so. If I’m a company and I make my revenues by selling products to consumers, then my revenues all come from after-tax disposable income. If my revenues come by selling products to companies, then they come from tax-deductible corporate expenses. And if my revenues come by selling products to the government, then they come from tax revenues themselves. None of this helps to determine how much of those revnues should be taxable.

Another reader emails to say that removing the tax-deductibility of debt interest would “penalize investment”. In fact, it would just put various different types of investment — equity and debt — on a more level playing field. And we have a public interest in encouraging equity rather than debt investment: if anything the playing field should tip the other way.


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