Primer: The Importance of Interest Deductibility to Businesses and the Economy

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The stated goals of tax reform are to boost the U.S. economy, increase investment, create more jobs, and foster innovation. With a cumbersome, outdated, and bloated tax code, reform has the potential to provide a significant boost to the U.S. economy. However, focusing solely on lowering rates may lead to harmful policy outcomes. This primer outlines interest deductibility (ID), its importance to businesses and the economy, and the negative effects of any limits on interest deductibility.

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Key takeaways include:

Interest expense is a cost of doing business that has been fully deductible from taxable income since the start of the modern tax code in 1921. Interest deductibility is used by businesses of all sizes, in all industries, and of all legal forms. It is not a tax expenditure, a loophole, or designed to boost a special interest.

A new tax targeting interest will raise the cost of capital for companies. On its own, this policy will reduce investment in the United States and lower economic growth.

Limiting interest deductibility to “pay for” tax reform reduces long-run growth by $33 billion in today’s economy and hits all industries and all states with two-thirds of the effect felt in the first decade. The increase in the cost of investment from limiting interest deductibility more than offsets the combined benefits of lower tax rates and efficiency gains from more equal tax treatment of debt and equity.

Concerns about asymmetric treatment of debt and equity financing in the tax code do not justify limiting interest deductibility for several reasons.

Tax penalties on equity and tax exemptions at the lender level are the root causes of the asymmetric treatment of debt and equity financing. As an ordinary cost of doing business, interest expense is rightfully deductible, while interest income is generally taxed.

At the same time, there is no evidence that interest deductibility has led to an overleveraged corporate sector. In fact, limits on interest deductibility could lead to financial instability.

Equity and debt financing are not functional equivalents. The two forms of financing serve distinct purposes for businesses and are not substitutes. Therefore, different tax treatments are warranted.

Limiting interest deductibility does not support the goals of tax reform. It reduces economic growth, lowers investment, and makes the U.S. a global outlier in tax policy.

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