Full Interest Deductibility Is Essential To A Pro-Growth Tax Code

Border adjustability. Corporate integration. Lower rates. Simplification. As the tax reform debate continues to heat up, it’s easy to lose sight of the real objective amid all the different proposals and priorities. Most would agree we need to create smart, principled tax policy that helps unlock long-term growth in the American economy. While nothing is ever certain — apart from death and taxes — one sure way to undermine this goal is to introduce a new tax on business interest expenses.

Interest deductibility is a product of basic accounting. It is neither a loophole nor a special interest benefit. It is accounting 101. The U.S. tax system was designed to tax net income — revenue minus costs. Curtailing the deductibility of interest would violate that principle because the interest incurred while borrowing to finance operations or investment is a normal cost of doing business. That is why it has been recognized as such since the creation of the modern U.S. tax code more than one hundred years ago.

Interest deductibility is vital to American businesses and economic growth. Companies in all sectors of the economy borrow to finance investments or meet obligations. Research shows 75 percent of startups and 80 percent of small businesses rely on debt financing. Without access to affordable credit, these companies will struggle to expand and add jobs. As we search for ways to catalyze economic growth in the U.S., the last thing we should do is make it harder for companies to access capital that can be used to make investments, expand operations, and create more jobs.

DEBT VS. EQUITY: A FALSE EQUIVALENCE

The notion that the tax code privileges debt over equity, and that this leads companies to take on dangerous levels of leverage, is a fallacy. Debt and equity financing are not interchangeable. There are a variety of reasons that a business would choose debt over equity when raising capital, most of which have nothing to do with taxation.

For one thing, many small- and mid-sized companies don’t have access to equity markets, making debt their only option. In contrast to the dilutive effects of equity, borrowing allows owners to access capital while retaining full control of their business. Debt is also a more cost-effective financing solution than equity because it is more secure for investors, who charge a premium for the risks associated with equity. Therefore, on both sides of the equation, debt and equity play separate and distinct roles in capital formation.

INTEREST DEDUCTIBILITY IS A SOURCE OF STABILITY

Recent research by leading economists from Duke, UPenn, and Washington University in St. Louis indicates that the tax treatment of business debt does not lead to dangerous levels of leverage. Looking at debt levels between the 1970s and the early 2010s, these economists conclude that leverage among U.S. companies remained fairly stable. In a separate study, Nobel Laureate Merton Miller found that debt levels remained constant at nonfinancial firms, even as tax rates quintupled and increased the value of interest deductibility.

On the other hand, removing interest deductibility would destabilize the U.S. economy. Access to affordable credit provides certainty and flexibility for companies in both good and bad times. Many companies draw on credit for working capital to finance operations during down cycles. What’s more, a new tax on business interest expense has the potential to devastate the corporate bond market — one of the great drivers of American competitiveness in the global economy. Worst of all, these effects would only become more harmful over time; as interest rates inevitably rise, the cost of capital will increase further.

Highly regarded economists have also weighed in on the issue of interest deductibility and financial stability. In a recent study, economists Brent Glover, Joao Gomes, and Amir Yaron write that increasing the cost of capital by limiting interest deductibility would cap the size of firms and force them to rely more on operating leverage. This increase in risk would lead to greater odds of default, resulting in more volatility throughout the business sector.

100 PERCENT EXPENSING IS NO SUBSTITUTE FOR INTEREST DEDUCTIBILITY

Contrary to some tax reform proposals, full and immediate capital expensing is not an acceptable tradeoff for interest deductibility. For starters, it would offer no benefit to small businesses, which are already able to expense annual capital expenditures. For larger companies, such plans would amount to Congress raising their taxes by eliminating interest deductibility and lowering them to a lesser degree through expensing. That’s a far cry from pro-growth tax reform.

Once again, research supports these arguments. A recent Goldman Sachs Economics Research note predicts that proposals to eliminate interest deductibility in favor of 100 percent expensing “would raise the user cost of capital and reduce investment in the longer run.”

In the near term, cash flows would be boosted by pulling forward depreciation schedules, which would compensate for the loss of the interest deduction. “After the first year, however, the impact on cash flow would begin to decline and eventually turn negative,” the Goldman Sachs study warns.

Simply put, limiting or eliminating interest deductibility is bad for business, which makes such proposals bad for workers, consumers, and the economy at large. Altering the current tax treatment of interest expense deductions will mean greater costs and more uncertainty for American businesses and their employees, making them less competitive in the global economy. Full expensing will neither address these concerns nor spur the kind of investment needed to fuel sustainable, long-term growth. After all, you can’t expense what you can’t afford.

UNINTENDED CONSEQUENCES

These are just the immediate dangers. Numerous policy proposals would also suffer if we limit interest deductibility. For example, President Trump has announced his desire for a $1 trillion infrastructure plan based in large part on public-private partnerships. Congressional leaders have discussed similar proposals, with anticipated leverage ratios of up to five-to-one. Of course, limiting interest deductibility would undermine these plans by increasing the cost of capital and making such investments less attractive.

AT THE END OF THE DAY, THE GOAL OF TAX REFORM IS TO PROMOTE GROWTH, ENCOURAGE JOB CREATION, AND BOOST THE AMERICAN ECONOMY. IF CONGRESS AND THE NEW ADMINISTRATION ARE SERIOUS ABOUT UNLEASHING THE NATION’S ECONOMIC POTENTIAL, THEY SHOULD NOT ABANDON WHAT WORKS IN OUR CURRENT SYSTEM. AND INTEREST DEDUCTIBILITY WORKS.