A recent American Action Forum piece advocates for eliminating interest deductibility, citing the differing tax treatment of debt and equity financing as the impetus for such a policy change. The authors argue that interest deductibility results in a “subsidy” for debt-financed investment when compared to equity-financed investment. However, this approach fails to account for the non-tax reasons why businesses choose debt instead of equity, and subsequently prescribes a policy solution that will harm long-run growth.
Equity financing is not a substitute for borrowing. For many businesses, the decision to borrow is made without the tax treatment of financing options in mind. Not all businesses have access to equity financing, and even if they do, equity financing can be a costly way to access capital that results in a business owner having to sell part of his or her company. Debt financing, on the other hand, allows for access to capital that businesses need to finance growth and create jobs.
Additionally, research shows that the tax treatment of interest does not have a significant practical effect in terms of businesses choosing to use debt instead of equity.
Even if the goal is to equalize the perceived tax treatment of debt and equity financing, the proper policy approach would not be to enact a new tax on business investment by eliminating interest deductibility. Instead, as has been previously advocated, policymakers should work to eliminate the double taxation on equity financing.
Below, please find excerpts from research that underscore the role and value of interest deductibility to businesses.
Not All Economists Agree Interest Deductibility Encourages Debt Over Equity
According To John Graham, Mark Leary, And Michael Roberts, The Tax Code Does Not Have A Significant Effect On Leverage. “The results in Panels A and B of Table 4 reveal the following inferences. First, while the shift in leverage policy was preceded by a substantial increase in corporate tax rates, there is little statistical association between tax rates and aggregate leverage once we control for common trends and other leverage determinants (column 1). Coefficients on the net tax incentive are insignificant both in levels and first differences. Closer inspection of Figure 9 reveals a significant delay between changes in tax rates and movements in aggregate leverage. If recapitalization is costly, corporate leverage may not respond immediately to an increase in tax rates, but tax may still affect the choice of security the next time a firm raises raises external capital. However, even when we account for the possibility of a delayed reaction to the tax law change using a distributed lag model with up to 8 lags of the corporate tax rate (unreported), we fail to find a positive relationship between tax rates and aggregate leverage.” (John Graham, Mark Leary, And Michael Roberts, “A Century Of Capital Structure: The Leveraging Of Corporate America,” NBER, 8/9/14)
Dr. Robert Carrol And Thomas Neubig Show That Interest Deductibility Is Not The Root Cause Of The Tax Bias For Debt Financing. “Interest deductibility is not the root cause of the tax bias for debt financing. Rather the tax bias results primarily from other aspects of the U.S. income tax system: The double tax on corporate profits raises the tax cost of equity as compared to debt financing. Thus, limiting the deductibility of interest to address the over-or-double-taxation of equity-financed investment in the corporate sector would be at cross purposes with other tax and economic policy objectives…While promoting economic neutrality through more even treatment of economic activity is often viewed as a reasonable policy objective, this may be at cross-purposes if this comes at the expense of raising the overall tax on the return to investment and indirectly taxes non-profit organizations and retirement savings.” (Drs. Robert Carroll and Thomas Neubig, “Business Tax Reform and the Tax Treatment of Debt,” Ernst & Young, 5/12)
Given That Nonfinancial Leverage Remained Constant Despite The Supposed Tax Advantages Of Debt Financing, Nobelist Merton Miller Concluded, “The Tax Advantages Of Debt Financing Must Be Substantially Less Than The Conventional Wisdom Suggests.” “A disequilibrium that has lasted 30 years and shows no signs of disappearing is too hard for any economist to accept. And since failure to close the gap cannot convincingly be attributed to the bankruptcy costs or agency costs of debt financing, there would seem to be only one way left to turn: the tax advantages of debt financing must be substantially less than the conventional wisdom suggests.” (Merton Miller, “Debt And Taxes,” Journal Of Finance, 5/77)
Instead Of Double-Taxing Credit, We Should Stop Double-Taxing Equity
Debt Financing Only Has A Tax Advantage Over Equity Because Equity Is Arbitrarily Over-Taxed. “The tax system provides a relative advantage to financing capital expenditures through debt because under current tax law, businesses can deduct their interest payments on the debt instruments, but dividend payments to shareholders are not deductible. Thus, equity is disadvantaged because it is double taxed while debt correctly faces only a single layer of taxation. On occasion, policymakers have proposed fixing this inequity by eliminating or reducing the interest deductibility for businesses. This would be the wrong policy. Instead, Congress should eliminate the double taxation on equity financing to equalize the tax treatment of the two means of raising capital.” (Curtis Dubay, “Taxation of Debt and Equity: Setting the Record Straight,” Heritage Foundation, 9/30/15)
According To The Information Technology And Innovation Foundation, It Would Be Better To Deduct Dividends Than Eliminate Interest Deductibility. “Eliminating deductibility would have a significant negative impact on many capital-intensive industries, however. It also violates the basic principal that if a payment is taxed as income for the recipient, it should normally be treated as a deductible expense for the payer. It would be better to eliminate the discrepancy between debt and equity by allowing companies to deduct dividends, thereby eliminating the double taxation of income at both the corporate and individual level.” (Joe Kennedy, “Five Must-Haves (and Five Nice-to-Haves) for Pro-Growth Corporate Tax Reform,” ITIF, 2/2017)
Leveling The Playing Can Be Done By Eliminating Taxation At The Corporate Or Shareholder Level, Rather Than Subjecting Debt-Financed Investment To Two Layers Of Tax. “The real difficulty with the tax treatment of businesses is the added layer of corporate tax. Leveling the playing field in a pro-growth manner can be done by eliminating the tax at the corporate level or the shareholder level, resulting in one tax on corporate returns, not two. It should not be done by subjecting debt-financed investment to two layers of tax.” (Stephen J. Entin, “Addressing Poor Arguments Against The Interest Deduction,” Tax Foundation, 8/16/16)