on February 26, 2007.
The third chapter of the 2007 Economic Report of the President is a polished commentary on the ins and outs of capital taxation. It would make a fine addition to any reading list on tax policy. There's only one problem: It's 20 years out of date.
President Bush's economists beautifully lay out many time-honored principles of public finance, such as:
- Lowering taxes on capital increases capital formation, productivity, competitiveness, and the U.S. standard of living.
- Eliminating the corporate income tax because, in addition to discouraging capital formation, it favors debt over equity, retained earnings over dividends, and noncorporate over corporate businesses.
- Expensing is equivalent to the total elimination of income tax on the normal return on investment. With expensing, however, supranormal returns (returns in excess of opportunity cost) are still subject to full tax.
- Expensing provides more investment incentive per dollar of government revenue loss (more bang for the buck) than a reduction in the corporate statutory tax rate. That's because only investment in new capital gets the tax break. The resulting increase in new capital, however, reduces the value of old capital. Transition relief for the old is costly and would largely eliminate the economic advantages of expensing over a rate cut.
Those nuggets of knowledge are not as central to policymaking as they once were. The time is passing when U.S. economists can make recommendations about U.S. tax policy without any knowledge of the tax policies governing businesses in Asia and Europe. Nowhere in the 32 pages of the president's report is there any mention of how other countries tax capital.
That would be OK if we all lived in a bubble. But, as the economists themselves keep telling us, there's a whole lot of globalizing going on. In the 21st century, how we tax business within our borders is not independent of how other countries tax business within their borders.
The most striking global development in corporate taxation is the worldwide outbreak of statutory rate cuts. Most recently Tax Analysts reported that the average corporate statutory tax rate in the European Union dropped from 43 percent to 33 percent from 1996 to 2005. And more cuts — including Germany's — are on the way. The Tax Foundation has also done its part to draw attention to the issue. (See, for example, materials from "Global Trends in Tax Reform: Are There Lessons for the U.S.?" available at http://www.taxfoundation.org.)
Sooner or later the United States will have to respond — to keep evasion at manageable levels, to relieve the mounting pressure on failing transfer pricing rules, and to attract capital, particularly intangible capital that thrives in a low-rate environment.
This article discusses a related development in corporate taxation: paying for statutory rate cuts with broad restrictions on interest deductions. The proposed limitations are distinctly different from governments' previous efforts to restrict interest deductions. In the past, interest deductions were restricted only to combat "abusive" situations. Two examples are thin capitalization rules (to prevent very high debt-equity ratios) and restrictions on deductions for equity-like debt (to crack down on high-yield junk bonds and contingent-payment securities). Currently only two European countries — Denmark and Germany — are seriously considering across-the-board limitations on interest deductions, but the moves deserve extra attention because they represent a radical approach to corporate tax reform.
Tax reformers always say you should lower the rates and broaden the base, but to pay for rate reductions they usually look to eliminate tax breaks, like credits and deductions, that generations of politicians have piled into the law to subsidize their favorite constituencies. Interest expense has never been on anybody's list of tax expenditures. So are the Danish and Germans really reforming their corporate taxes or are they just engaged in an unprincipled money grab?
Since the summer of 2006, the German government — a "grand coalition" of the two major parties, the conservative Christian Democrats and the left-leaning Social Democrats — has been advocating a reduction in the corporate tax rate from 39 percent to slightly below 30 percent. Interpreted through the lens of U.S. politics, you might view this as a concession to the conservative right. You would be wrong. Germany, home to Europe's largest economy, can no longer tax corporations at a high rate when their profits can easily slip into any of dozens of low-rate jurisdictions. The Germans are not trying to gut their corporate tax. They are trying to preserve it.
To offset the cost of lowering corporate rates, Finance Minister Peer Steinbrueck, a Social Democrat, proposed that Germany become the first nation in the EU — and probably in the industrialized world — to institute a broad-based elimination of deductions for corporate interest payments. Under that version of the plan, there would be no distinction between related- and unrelated-party loans, nor between loans from resident and nonresident lenders.
The proposal provoked a firestorm of protest from the business community. German businesses traditionally use a lot of debt to finance investments. Small businesses and highly-leveraged companies yelled the loudest. U.S. multinationals operating in Germany also complained. Even the government's own economics minister, Michael Glos, publicly opposed the plan.
So Steinbrueck went back to the drawing board, and by November he negotiated an agreement on a modified plan. The new proposal would disallow all net interest expense that exceeds 30 percent of taxable income before interest income and interest expenses are deducted. The rule would apply only to businesses that incur net interest expense in excess of €1 million per year. A 130-page technical draft of the total reform package, scheduled to take effect on January 1, 2008, was released on February 5.
More recent developments in Denmark are following a similar pattern. Like the Germans, the center-right government of Denmark wants a lower tax rate. In the Danish case, the proposed reduction is from 28 percent to 22 percent. To reduce leveraged buyouts and to help pay for the rate cut, Danish Minister of Taxation Kristian Jensen on February 1 published a draft reform bill that includes severe new restrictions on the deductibility of interest. Specifically, the new plan allows only 55 percent of net interest expense in excess of DKK 10 million to be deducted. Further, net financing expenses would not be deductible to the extent they exceed a cap equal to a standard rate of return (currently 6.5 percent) multiplied by the value of the company's assets.
As in Germany, business groups in Denmark have been vocal opponents of the Danish plan. Most notably, as the Financial Times reported on February 3, the huge, Copenhagen-based shipping company A.P. Moller-Maersk threatened to move some of its operations out of Denmark if the legislation is enacted. Nevertheless, according to the Bech-Bruun Law Firm, the Peoples Party and the Social Democrats are likely to support the proposal and to provide a solid majority for approval by the Danish parliament in March.
Rumblings in the U.K.
Debt-financed takeovers of some of Britain's largest employers have sparked concerns about the tax advantages of the deals. On February 7 the GMB — Britain's 600,000-member general trade union — urged U.K. Chancellor of the Exchequer Gordon Brown to end the tax deduction for interest payments on loans used by venture capitalists to buy companies. According to the GMB, venture capitalists load companies with excessive debt and then use massive layoffs to trim costs.
In December 2006 the newly formed Oxford University Centre for Business Taxation, headed by economist Michael P. Devereux, held a full-day workshop on the possible elimination of interest deductions. Devereux said that, in addition to the antitakeover sentiment voiced by the GMB, the growing pressure to limit interest deductions stems from both practical concerns over lost revenue and academic concerns over the uneven treatment of debt and equity.
The overarching argument against the idea — similarly expressed in Denmark and Germany — is that businesses have built their balance sheets around their ability to deduct interest expense and that the costs of restructuring would be large. On February 15 the Financial Times put it more bluntly: The inability to deduct interest would be "severely disruptive" and would prompt most companies to "radically" restructure their balance sheets.
The corporate income tax is an arbitrary tax. Sometimes legal textbooks refer to the corporate tax as part of a "classical" system, but that labeling should not fool us into venerating the status quo. There is nothing sacred about income from corporate equity capital. It does not merit its own special tax. If, however, we are going to tax it, there is no principled reason we should fail to tax capital income financed with debt as well. In fact, if it is accompanied by a rate reduction, a corporate tax without interest deductions is economically superior to the conventional version.
In 1992 the U.S. Treasury Department proposed restructuring the corporate income tax into a comprehensive business income tax that did not include an interest deduction. The main sweetener for the proposed base broadening was the exemption of dividends and interest from taxable income at the individual level. Treasury tried to blunt concerns about the disruption such a change would have on balance sheets by suggesting that the proposal be phased in over 10 years. The proposal has gotten nowhere, but in light of developments in Europe, could it be worth a new look?
Of course, instead of taxing income from both debt and equity — that is, by unpopular tax increases — the playing field between the two could be leveled by allowing deductions for equity investment as well as debt. That's the approach taken by Germany's neighbor to the west, Belgium. Since 2006 Belgian corporations have been allowed to deduct an amount deemed to represent a normal return on equity. That amount, called notional interest, is computed by multiplying the total equity of the firm by the average interest rate on government bonds.
While the president's economists are recycling textbook wisdom, the world is changing. First it was lower statutory corporate tax rates. Now a new trend may be emerging in which the sharp tax distinction between debt and equity is being blurred. The White House and Congress should take notice.