Setting The Record Straight On Interest Deductibility In The Economist

In its February 2 piece entitled “What If Interest Expenses Were No Longer Tax-Deductible?“, The Economist incorrectly describes interest deductibility (ID) as a tax break 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 United States since the creation of the modern tax code more than 100 years ago.

First, ID is a basic principle of accounting, not a loophole or carve out for special interests. The U.S. tax code taxes businesses based on profit—revenue minus costs. Interest expenses are a cost of borrowing and, as such, are properly recognized as a normal cost of doing business.

Next, The Economist‘s piece claims that ID leads companies to over leverage, thereby increasing risk in the economy. This claim is simply not supported by the facts.

Nobel Laureate Merton Miller’s study on leverage found that even after tax rates quintupled—thus increasing the value of the interest deduction—leverage remained constant at nonfinancial firms. Miller concludes that “the tax advantages of debt financing must be substantially less than the conventional wisdom suggests.” Similarly, more recent research published by leading economists from Duke, UPenn, and Washington University in St. Louis finds no evidence that the tax treatment of debt leads to dangerous levels of leverage.

Additionally, the piece argues only companies with high levels of debt would be harmed. In reality, eliminating ID would harm businesses of all sizes and across all sectors by multiplying the cost of borrowing. In terms of financial instability and risk, research published by the St. Louis Federal Reserve shows limiting ID would increase volatility within the economy, largely due to higher costs of capital, and lead to higher default rates.

The article notes that we currently have historically low interest rates but fails to reach the obvious conclusion that this is masking the negative impacts such a change would have in the long run. As interest rates normalize and bond yields rise, the cost of capital will rise as well, increasing the financial burden on companies throughout the economy.

The Economist also conflates debt and equity financing. There are, of course, a number of non-tax reasons why a business might choose debt over equity when raising capital. For many small businesses without access to public equity markets, debt 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.

We also disagree with the conclusion that now “could be a dangerous time to fiddle with the tax code.” Pro-growth tax reform is more critical than ever, but changing the tax treatment of interest expenses would undermine the success of any tax reform package. Virtually all businesses rely on credit, so limiting ID would negatively impact growth and job creation throughout the American economy.

Overall, the piece ignores 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.