Pennsylvania needs real tax reform focused on economic growth

Published in The Philadelphia Business Journal, August 2, 2013,

Pennsylvania needs real tax reform focused on economic growth

By Matt McDonald, Treasurer of the BUILD Coalition

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When considering tax reform, business owners think about simplification — clearing the underbrush that has grown since the last overhaul in 1986. It’s no secret that more than 15,000 new tax expenditures have been added to the tax code in the last quarter century. But instead of focusing on that clutter, some policymakers are targeting a fundamental, 100-year-old component of the tax code — interest deductibility. Rather than clearing the underbrush, Congress is considering chopping down the redwoods, even as the evidence shows that this approach to reform will cost the Pennsylvania economy $1.3 billion over time.

Interest on business debt has rightfully always been considered a basic operating expense. Businesses of all sizes and in all sectors use borrowing to grow, whether to finance investments in new factories or equipment, manage payroll, or just get a new project off the ground. In fact, 75 percent of start-ups and 80 percent of small businesses — which create two out of every three new jobs — borrow money as a part of regular business. Because the ability to borrow is universal and fundamental to all businesses, it has been fully deductible since the inception of the U.S. tax code more than 100 years ago.

Despite the benefits of business borrowing, a number of policymakers are arguing that limiting interest deductibility can help reduce business tax rates. Yet these proposals violate the main goal of tax reform — spurring economic growth.

According to a recent Ernst & Young study, limiting interest deductibility will reduce investment, economic growth and economic welfare. Further, this proposal reduces growth in all industries and in all 50 states. The study, which specifically examined the impact of a plan for a 25 percent across-the-board limit on corporate interest expenses to finance a 1.5 percent cut in tax rate, found that Pennsylvania’s long-run growth would be reduced by $1.3 billion. Industries central to Pennsylvania’s economy, such as business services, manufacturing, and wholesale and retail trade all take significant economic hits as well.

Why is this policy so important? When companies want to grow, they need to finance that growth, and debt is a tool do so. Like all other taxes, a new tax targeting interest on debt makes financing growth more expensive. The EY study found that the new marginal effective tax rate for investment would rise by 9.6 percent in the corporate sector under this plan. The result is less investment and less growth in the United States. Over the long run, in today’s dollars, gross domestic product and investment would drop by $33.6 billion and $6 billion, respectively.

Lawmakers know that tax policy can exert powerful incentives or disincentives for working, saving, investing, and allocating capital and labor. There are ripple effects that accompany any increase in the price of capital, which is akin to raising the basic costs of doing business — that new plant or store suddenly becomes more expensive. This discourages investment and new business endeavors in the short term, and economic growth and job creation in the long run.

This not only hurts large businesses, but small businesses as well. To finance growth, small businesses and start-ups are less likely to have the option of equity financing or a steady stream of profits to re-invest. They turn to bank loans or credit cards to make those critical first investments in office space, computers, and equipment to get off the ground. In an economy barely moving forward, we need to encourage innovation and entrepreneurship, not make things tougher on our engines of growth.

Tax reform undoubtedly needs to happen. However, its goal should not be to pass law and call it reform, but to enact real changes that help grow the U.S. economy. Interest deductibility is a long-standing and critical component of all business operations in the United States. When looking to clean up the tax code, Congress should concentrate on the underbrush — the 15,000 complicating provisions of the past decades — and not the oldest trees in the forest.

Matt McDonald is treasurer of the BUILD Coalition, a group of businesses and associations advocating for maintaining 100 percent interest deductibility within tax reform.

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