Proposals to limit the business interest deduction as part of tax reform are based on a number of misconceptions. Unfortunately, a recent report by the Heritage Foundation perpetuates two of these: the notion that full interest deductibility can be replaced by full and immediate expensing, and the myth that the current tax treatment of interest encourages businesses to use debt instead of equity.
Full expensing is not a suitable replacement for full interest deductibility. Across the economy, expensing is already available to American businesses. Our current system has depreciation schedules that allow firms to expense capital goods over many years. Temporarily changing the timeline to allow for immediate expensing, as proposed in the latest framework, would give certain capital-intensive businesses a short-term boost while permanently removing a normal cost of doing business for companies across industries. At best, this would produce an economic sugar high at the expense of a time-tested, pro-growth policy.
In addition, the current tax treatment of interest does not incentivize businesses to use debt over equity, nor does it encourage overleveraging. Nobel-Prize winning economist Merton Miller found that even when the corporate tax rate quintupled, dramatically increasing a businesses’ incentive to borrow, the debt levels at non-financial firms remained the same. Other economists from Duke University, Washington University in St. Louis, and the University of Pennsylvania have arrived at similar conclusions. This research shows that businesses choose debt financing for a variety of reasons unrelated to the tax code.
Debt and equity are not interchangeable financing options. Many businesses lack access to equity capital markets. Even when equity financing is available, it typically more expensive than borrowing and often involves relinquishing some level of ownership. Borrowing is therefore often the best way for businesses to fund their operations, create jobs, and grow.
By placing restrictions on a business owners’ ability to borrow, lawmakers are undermining the goals of tax reform, imposing a new tax on job creators and impeding their ability to operate their business.