Setting The Record Straight: The Economist’s “The Great Distortion” Misses The Mark

Dr. Rebel Cole, Professor of Finance at DePaul University’s Driehaus College of Business, has issued the following statement in response to an article in The Economist entitled “The Great Distortion:”

The Economist‘s piece misses the key point that allowing firms to deduct interest payments enables firms to raise capital needed for new investments. Limiting interest deductibility, even if coupled with a corporate rate reduction, would stifle investment, thereby reducing employment and output. If the goal of tax reform is to promote growth, then preserving full interest deductibility is essential.

A recent study by EY identifies the pitfalls of a tax system that includes a 25 percent across-the-board limitation on interest deductibility in order to fund just a 1.5 percentage-point reduction in the corporate tax rate. The resulting tax structure would reduce long-run economic growth by $33 billion, while also decreasing output in all 50 states and across all industries.

Further, equity markets are out of reach for many firms.  Fortunately, debt financing offers growth opportunities to dynamic businesses that are not available with equity financing. Indeed, four out of five small businesses and three out of four start-up companies use debt financing. Additionally, contrary to popular perception, there is no relationship between interest deductibility and the amount of non-financial leverage taken on by non-financial businesses, as noted by Nobelist Merton Miller.

As for dealing with “the great distortion,” a tax structure that removes distortions in the tax code promotes economic efficiencies and growth. Such systems are realistic and have been enacted in other jurisdictions.

I encourage public discussion of the importance of interest deductibility.  Unfortunately, the assertions made in The Economist‘s piece miss the critical role that interest deductibility plays in encouraging business investment and economic growth.

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