Opinion

Felix Salmon

How to reduce the deductibility of interest payments

By Felix Salmon
February 23, 2012

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.

Comments
19 comments so far | RSS Comments RSS

I’m no expert.. but this idea seems to move our economy in the right direction. thanx for the explanation.

Posted by Train_Ryder | Report as abusive
 

Despite what Felix says, there’s a great philosophical reason that interest payments should be 100% deductible – they are taxable income to the recipient. It’s the same logic as to why other ordinary business expenses (payroll, purchases of goods and services from other companies) are deductible. The concept is both (i) that a tax is levied on “income”, which for corporations is revenue less expenses and (ii) that expenses of corporations essentially always end up as taxable income for someone else (or, in some cases such as property taxes or employer payroll taxes, payments to the government). The difference in tax-free muni bond yields vs. taxable bond yields also demonstrates that the tax treatment of interest is logical – the after-tax yield of a similarly-rated bond is almost identical.

The real outlier in the tax code is the treatment of dividends, not the tax deductibilty of interest. Dividends are taxed as corporate income and then again as income for the recipient. There’s no reason that simply paying a dividend should create a tax liability – there should either (i) be a corporate deduction for dividends paid or (ii) be no personal income tax paid by the recipient of dividends. Within the corporate tax code, the Dividends Received Deduction recognizes this issue and takes an approach that broadly follows my proposal (ii).

(Another alternative would be to treat every corporation like an S corp, and have shareholders pay tax on their respective shares of income. I rule out that theoretically appealing alternative due to the administrative nightmare of a large public company having to apportion income to thousands upon thousands of shareholders, many of whom are shareholders for less than a year.)

Posted by realist50 | Report as abusive
 

realist, the problem with S corp taxation is that you are stuck paying heavy taxes without actually having the cash to pay them with.

A small business growing rapidly might “earn” $200k in a year, but might need to keep half of that in the business to finance the growth. You can have a good six-figure income and still be living on Ramen noodles.

Posted by TFF | Report as abusive
 

I agree with realist….the issue is symmetry of income and expense in the tax regime…

A further consideration is that expenditures for PPE, including for certain intangibles such as patents, can be financed by LEASING the property…..would you disallow rent expense as a deduction? You might say that you’d disallow interest expense deduction for the LESSOR….making the latter effectively finance with all equity….but that then raises the question as to whether financial institutions as well as industrial companies would be denied deductibility of interest expense….I count venture firms as financial institutions, too….so if banks can deduct interest expense why not leverage the acquisition of equipment and lease it to a user passing the tax benefit of interest expense deductibility to the user in the form of (lower) equivalent rent expense…deductible to the user?

this quickly becomes a very tangled web….

Posted by NotoriousBOB | Report as abusive
 

TFF, your example was my life in the 90s. Our fast growing S corp company was profitable, but we much of the profit was in receivables that were constantly being re-invested, yet were taxed. Having to pay taxes on income that wasn’t being distributed to shareholders or accumulated in a bank account probably kept us from hiring 3 engineers, which would have further accelerated our growth.

And then to make it worse, the S corp classification cost me a lot of money, for although the company had a successful “exit”, when I re-invested the capital gains in new ventures, the investments were not excluded from capitals gains tax, as they would have been if it were not an S corp. Lesson to anyone starting a company that they hope to grow: don’t use S corp classification.

Posted by KenG_CA | Report as abusive
 

Notorious BOB – great point regarding leasing. Your leasing scenario doesn’t necessarily require U.S. financial institution interest expense to be fully tax-deductible. As long as interest is tax-deductible for foreign companies/banks, I imagine that they would find a way to use that to their benefit as lessors in the U.S.

More broadly, removing or limiting tax deductibility of interest would create our own version of an Islamic finance industry – ongoing efforts to structure transactions to relabel what’s really “interest” as some other type of expense.

Posted by realist50 | Report as abusive
 

>the effective marginal tax rate on the same investment made with debt financing is minus 60 percent

WTF? I’m not an accountant but I once ran a corporation and I’m mystified by this. I don’t recall the government rebating 60% of my interest costs. I was able to deduct interest, but the money wasn’t free by any means, precisely because I had to pay interest on it.

If interest is not 100% deductible, then a business that has zero profit after interest payments will still have taxes due and thus be in danger of bankruptcy, so the change you propose would make the system more fragile. Unless businesses reacted to this danger by reducing borrowing, which seems to be your overall goal. But then we get the Islammic issue someone aluded to, where people come up with all sorts of stock-bond hybrids to game the system.

Also, as others have noted, the real problem is double taxation of profits and dividends.

If the governments want more money from interest, then get rid of some of the tax exemptions which allow persons or entities to receive interest without being taxed on it: non-profits, pension funds, Roth IRAs, foreigners who receive interest (and also dividends) from US payers without paying taxes, municipal bonds, etc.

Posted by revelo | Report as abusive
 

realist50…right on foreign institutions financing leasing transactions…..also the Islamic finance angle….they always have an interest, in my experience, in certain leasing type transactions…because “rent” is not interest….and there is or can be an element of residual (asset) upside and downside….

Posted by NotoriousBOB | Report as abusive
 

“Lesson to anyone starting a company that they hope to grow: don’t use S corp classification.”

I think my brother has switched. :) But there were a couple years that he needed a six month extension to make his tax bill. Kind of ridiculous given his nominal earnings at the time, and I shuddered at the debt he was racking up. Guess it all worked out in the end for him… As you say, it doesn’t seem to be an unusual story.

“I’m not an accountant but I once ran a corporation and I’m mystified by this. I don’t recall the government rebating 60% of my interest costs.”

Accelerated depreciation, perhaps? Over the past five years there have been a bunch of ideas implemented to try to get people to invest. It is almost to the point where the government will finance it for you! (Except you need to carry the debt on your books for a few years, and you still need to pay back the principal.)

Posted by TFF | Report as abusive
 

Just because you borrow doesn’t mean you don’t have cash. Nothing about debt financing new equipment or any other thing a company needs to grow necessarily means that the company will be over-leveraged. Shouldn’t conflate stupid management with stupid tax policy, even if they do happen to work in parallel.

Posted by Eericsonjr | Report as abusive
 

Eericsonjr, are you talking to me? Or Felix?

Like KenG, my brother had much of his “earnings” tied up in receivables. That happens when a business is growing fast. And he did borrow — but banks aren’t all that eager to float $100 grand to a small company only a couple years old, even if business is booming.

Even intelligently managed companies (and I suspect most have a few operational road bumps as they grow) can be short on cash.

Posted by TFF | Report as abusive
 

TFF, we had the same experience with banks. Profits, 50-100% annual growth, and they would only lend against the equity in my home. And then they put so many conditions on the loan, that if we borrowed anywhere near the amount of our limit, we would be in technical default. They were useless to us, we never used the line of credit (it was a company selling computer hardware products, so it’s not like we had equipment they could put a lien on), and that was BEFORE banks got childish with sub-sub prime mortgages.

Posted by KenG_CA | Report as abusive
 

Why do we “we have a public interest in encouraging equity rather than debt investment”?

Posted by Danny_Black | Report as abusive
 

Different businesses have different profitabilities. Differing amounts of leverage can allow profitibility equalization between them. This could still be done but to a lesser extent under reduced tax deductibility. The two approaches, limiting leverage and limiting tax deductibility would put debt and equity on a more equal footing but there already are exemptions in corporate tax law that put debt and preferred equity on similar footings so you would also have to change that.

Posted by MyLord | Report as abusive
 

Felix, you declined to address the “Islamic leasing” program?

If interest paid is not deductible for banks, then you’ve dramatically changed the rules of play. I doubt you’ve thought through the implications of that one. (I doubt you are able to think through such a major change successfully.)

If interest paid *is* deductible for banks, but not for other corporations, then you simply shift from borrowing money to “leasing”. Good for banks (since they can effectively arbitrage the tax law), but not good for society as a whole.

We need to get away from taxing corporate income anyways. It doesn’t work (too many ways for multinationals to dodge) and it won’t ever be fair. the cash out, not the cash in.

Posted by TFF | Report as abusive
 

If you are a MNE headquartered in the US, and you borrow 100 in the market, put the 100 in as equity in your Belgian daughter, and then borrow the 100 from your Belgian daughter in order to finance investment in another foreign daughter, the US parent company has for tax purpose an interest bearing debt of 200, with all the interest deductible against US income.

The Belgian company has a taxable income of 100. But the Belgians have created a special “Notional Interest Deduction” (NID) tax system in order to attract financial activity from MNEs. They get a notional interest deduction in Belgium on the 100 they received as equity from the US parent, leaving no taxable income there.

One easy way to stop this kind of erosion of the US tax base is to introduce a cap on financial deductions, like for instance Germany has done. It may be linked to EBITDA or some similar financial number, disallowing deductions for net financial costs exceeding some percentage of this.

Debt structuring is one of the easiest ways to eliminate taxable income in MNEs. If you want to know more in depth about this, a good place to start is Kleinbard’s excellent recent paper “Stateless Income” which you may download here http://papers.ssrn.com/sol3/papers.cfm?a bstract_id=1791769

Posted by Gaute | Report as abusive
 

Sure companies pay a reduced tax rate using debt financing as the interest expense is like any other business expense, tax deductible.

Debt financing allows risk to be taken. The author’s premise that corporate debt financing contributes to systemic risk and economic crisis is wrong with no historical precedent.

The return to a company and thus a company’s shareholders increases when leverage is increased. Leverage has gotten a bad verdict in the court of public opinion due to the 2008 global economic crisis and rightfully so as the use of derivatives increased financial institutions leverage to disturbing levels. It was banks that engaged in excessive leverage, one sector, not corporations in general.

In the 2008 crisis individual companies were not guilty of excessive leverage, it was..
1) financial institutions through derivatives and creating an unhealthy volume of securitization: risky loans packed together called collaterized debt obligations (CDOs) and…
2) individuals themselves following through on home loans they could not meet the obligations of and did not understand in some cases.

So go ahead and discourage debt financing and you will discourage economic activity without addressing the actual cause of global economic risk. Still concerned? Put pressure on government to implement a greater % of the Dodd Frank legislation which addresses the actual systemic issues of risk better than the tax treatment of debt.

Don’t penalize those that take the financial risk with debt financing to supply jobs and earn a profit here in the U.S.

Not now anyway.

Posted by kenpstack | Report as abusive
 

Dear Mr. Salmon:

A good place to start discussion is to examine where
this whole idea of deducting interest started.

What was the reasoning for instituting this provision
in the tax code to begin with?

From my limited knowledge, I’m thinking that
maybe this idea might have been put into place because
the gov wanted to give a poor person the opportunity
to borrow money and start a business. If the gov
gave them a break, they could do it. If the gov
didn’t do this, then only filthy rich people could
swing in the ownership circles.

From my limited knowledge, I’m thinking that the
filthy rich abused the gov help provision. And if this was the case, then maybe you are correct…take the opportunity away from those that abused a break for the little guy.

But then, you’re running into this thing that has been the foundation of the Obama administration….unequality
for everyone…this person should be treated differently from that person based on some governmentally dreamed up definition. I’m getting absolutely totally sick of
this fueling of internal war…it certainly isn’t deserving of ANY peace prize. AND worse! The administration comes out and twists this bigotry as if it is all American, equal equal stuff when the truth is
that it’ll crumble our society.

Posted by limapie | Report as abusive
 

Hey Felix, just wanted to throw out a positive benefit from encouraging debt financing vis-a-vis equity in case you hadn’t considered it…debt financing implicitly encourages productive use of said financing. If my company raises 10m with no future obligations other than a promise to share a future cut of my profits my behavior is likely to be much different than if that 10m came with the strings attached that I have to pay 11.5m in 10 years time; I’m much more likely to put all of that money to productive use to ensure that I can replay that 11.5m in the future.

This isn’t intended to be a defense of the status quo; I don’t think 100% deduction is optimal (of justified) and I am very much in favor of that discussion you speak of. I just wanted to point out that I think wise public policy should indeed encourage debt financing over equity financing to a certain extent for this structural framework to encourage productivity.

Thanks for all of your great work.

Posted by Shaun0720 | Report as abusive
 

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