Research on interest deductibility highlights…

…its benefits for businesses

  • Why Businesses Use Debt And How Debt Benefits BusinessesDr. Rebel Cole provides an overview of the reasons why a business would use debt to finance a portion of its investments and explains why such financing would be beneficial to that firm. He finds that four out of five businesses use debt to finance at least some portion of their investments. While larger businesses, organized as corporations, and firms in asset-intensive industries (such as manufacturing and transportation) use more debt, on average, small businesses use one dollar of debt for each one-to-two dollars of equity. In addition, 75 percent of start-ups use some sort of debt financing at inception and this percentage remains relatively constant over the first five years of their operation.

…its importance to economic growth

  • Macroeconomic Analysis Of A Revenue-Neutral Reduction In The Corporate Income Tax Rate By An Across-The-Board Limitation On Corporate Interest Expenses: EY’s Quantitative Economics and Statistics (QUEST) Group finds that the effect of limiting the deductibility of corporate interest to its noninflationary component to finance a revenue neutral 1.5 percent reduction in the corporate income tax rate would reduce long-run economic growth by $33.6 billion and investment by $6 billion measured in terms of today’s economy. By industry, services, retail and wholesale trade, manufacturing, and construction take the biggest hits. California, Texas, and New York would see the largest drops in aggregate income, while Alaska, Delaware, Wyoming, and Connecticut would see the largest drops in GDP per capita.

  • Do No Harm: Keep Corporate Interest Fully Deductible: In an independent study, John Talisman argues that recent proposals to impose across-the-board limits on the deductibility of interest should be rejected for three main reasons. First, the current tax treatment of interest is appropriate and is not distortive, as interest on debt is an ordinary and necessary business expense. Second, current economic research suggests that the effects of debt bias appear exaggerated and to the extent that it exists, it does not significantly contribute to distress. Lastly, Talisman argues limits to deductibility will impede investment by raising the costs of capital. Adopting such a policy would make the U.S. an outlier relative to our major trading partners, according to Talisman.

…its role in promoting financial stability

  • A Century Of Capital Structure: The Leveraging Of Corporate America: John R. Graham of the Duke University Fuqua School of Business, Mark T. Leary of the Washington University Olin School of Business, and Michael R. Roberts of the University of Pennsylvania Wharton School provide an overview of the history of the use of debt and leverage among US corporations. The authors find no evidence suggesting that the tax treatment of debt has led firms to lever up. They also find that over the past several decades firm leverage has remained constant.
  • Corporate Taxes, Leverage, And Business Cycles: Brent Glover, Joao F. Gomes, and Amir Yarons analyze the effect of limiting interest deductibility on both financial and operational leverage. While limiting interest deductibility reduces financial leverage, because it raises costs on businesses, it reduces firm size and increases operational leverage significantly. Ultimately, they find that the negative impact of higher operational leverage on default rates and credit spreads outweighs the impact of lower financial leverage, leading to a less stable business sector.
  • Financial Distress In The Great Depression: John R. Graham, Sonali Hazarika, and Krishnamoorthy Narasimhan use firm-level data to study corporate performance during the Great Depression era. They find that tax-driven debt bias did not contribute significantly to the occurrence of distress.

Want more? Check out our Issue Briefs on our blog.