A March 1 POLITICO piece entitled “The Powerful Financial Reform Within The House GOP Tax Plan,” incorrectly describes interest deductibility (ID) as a tax provision that makes the economy riskier by encouraging debt financing. This is a simplistic view that mischaracterizes a fundamental feature of our economic system—one that has helped to drive growth in the U.S. since the creation of the modern tax code more than 100 years ago.
The article completely ignores the fundamental differences between debt and equity. There are, of course, a number of non-tax reasons why a business might choose debt over equity when raising capital. For many businesses without access to public equity markets, credit is often their only avenue for raising capital. And for those with access to equity markets, debt and equity financing are hardly interchangeable. In contrast to the dilutive effects of equity financing, debt allows owners to retain full control of their company. In short, debt and equity play fundamentally separate and distinct roles in capital formation.
The POLITICO piece also claims that interest deductibility leads companies to overleverage, thereby increasing risk in the economy. This claim is not supported by the facts. In reality, eliminating ID would harm businesses of all sizes and across all sectors by multiplying the cost of borrowing. Despite comments by St. Louis Federal Reserve Bank President James Bullard, research presented at a St. Louis Fed conference shows limiting ID would increase volatility within the economy, largely due to higher costs of capital, and lead to higher default rates.
That study, conducted by economists at UPenn and Carnegie Mellon, concluded that “contrary to conventional wisdom, we find that eliminating interest deductibility results in an increase in the default frequency and average credit spreads.” Eliminating interest deductibility—as the House Blueprint calls for—would actually increase market volatility and would significantly disrupt corporate bond markets.
Overall, the piece fails to acknowledge the critical role ID plays in the U.S. economy. The provision helps businesses of all sizes grow and compete globally. U.S. policymakers should maintain full interest deductibility to ensure tax reform efforts are supportive of economic growth.