Should interest expense costs be deductible? To business owners, accountants, and tax lawyers, the question seems totally out of left field. In their eyes, the cost of borrowing money is an expense like any other. Of course it should be deductible.
The owner's share of business receipts is what's left over after all expenses are paid -- whether to employees, suppliers, or bankers. Except in those relatively rare circumstances in which interest cost can be traced to exempt income, or when what is being called debt is really equity, or if related-party loans are used to shift income out of high-tax jurisdictions, interest should be deductible to correctly measure business taxable income.
Economists would agree that interest is an expense properly deducted for determining business profits. But to economists, the cost of borrowing stands apart from other business expenses because it is something more: a return on invested capital. It is what is paid to lenders over time after they have contributed money to fund capital formation. From an economic standpoint, that puts it on par with profits paid to stockholders. Both interest and profits are returns on capital.
Of course, there are differences between debt and equity. For example, lenders do not own the capital they finance. But that and other legal distinctions make no difference in most models that economists use to determine investment behavior and to assess the efficiency of tax systems. Income earned by holders of debt and income earned by stockholders are qualitatively equal determinants of capital formation. To assess the efficiency of a tax system and its impact on the size and mix of the capital stock, the total return on capital matters.
That is why economists' calculation of effective tax rates includes total taxes on debt and equity in the numerator and total returns to debt and equity in the denominator. That is distinctly different from effective tax rates calculated by accountants and reported in financial statements. Accounting effective tax rates include only taxes on profits in the numerator and profits accruing to shareholders in the denominator. If a corporation increases its debt-equity ratio, that has a major impact on its after-tax cost of investment, and that is reflected in a reduction in the effective tax rate calculated by economists. But that same corporation's reported effective tax rate would hardly change. The numerator and denominator of accounting effective tax rates decline roughly in proportion to each other when a business increases leverage.
In a world where there are no corporate taxes, the observation that interest expense is a return on capital does not add much to the discussion of tax policy design. After all, it comes naturally to all involved that interest should be deducted, and that natural inclination produces the fair and efficient result that economists want. There is no entity-level tax. Owners are taxed on their profits at the individual level. Lenders are taxed on their interest income at the individual level. Both returns on capital are taxed once.
Eliminating interest deductions would result in unfair and excess taxation of profits, and, to the extent investment is funded with equity, the effective rate of tax on investment could exceed the statutory rate. The deduction for interest serves a necessary purpose in the calculation of business profits under the individual tax. In this context, it is necessary to help promote economic neutrality.
But in a world with corporate taxes, all this changes. The corporate tax is an arbitrary tax with no solid economic justification. It puts an extra layer of tax on capital income, but only on capital income accruing to specific corporations. And of that corporate capital income, only the income funded with equity is subject to the tax. Corporate debt is favored over corporate equity. So for the corporate tax, the deduction for interest has the opposite effect it has for the individual income tax. It reduces neutrality.
The resulting distortions are large and pervasive throughout the corporate sector. Corporate investment funded primarily with debt can have an effective tax rate close to zero, while corporate investment funded primarily with equity is effectively taxed close to the statutory rate. Other tax breaks in the code, like accelerated depreciation, result in a parallel downward shift in effective tax rates.
The combination of debt finance and excessive tax depreciation can easily result in negative effective corporate tax rates on investment. In the extreme, 100 percent debt financing and expensing result in an effective tax rate equal to -35 percent.
Tax Reform 2013
If there must be a corporate tax, it would cause far less economic damage than it currently does if the deduction for corporate interest were eliminated and the revenue raised was used to lower the statutory tax rate. That would put all corporate investment on a more equal footing. Also, the reduction in the statutory rate would have several other benefits, including a reduction in incentives for multinationals to artificially shift profits and a reduction in distortions from incentive deductions in the code.
In response to any proposal like this, many would correctly argue that it would be far better to eliminate double taxation than to expand it through an elimination of interest deductions. In other words, instead of treating interest like taxable profits, we should treat profits like tax-free interest. But in light of tight budgets and the public's gut feeling that corporations should pay tax, eliminating the corporate tax may not be politically feasible. A revenue-neutral plan with a limit on interest deductions combined with a rate cut is a superior alternative to the status quo.
The deduction for corporate interest reduces the burden of an economically unjustified corporate tax. It lowers corporate effective tax rates. So many -- especially representatives of sectors like public utilities and manufacturing, with relatively high levels of debt -- will argue that limiting interest is a step in the opposite direction of where we should be headed. The problem with their approach is that while the interest deduction's diminishment of the effective corporate rate is a good thing, the unevenness of the benefit provided creates a whole new set of problems.
Moreover, this kill-the-corporate-tax defense of corporate interest deductions could be made for any corporate tax break. Widely accepted, it would stop corporate tax reform dead in its tracks. For corporate tax reform to move forward, tax benefits that unevenly reduce effective corporate tax rates should be curtailed and replaced with rate reductions that provide benefits across the board.
There is widespread agreement that the United States should follow in the steps of other nations and reduce its statutory corporate tax rate. Cutbacks to tax expenditures -- like accelerated depreciation, the section 199 deduction for manufacturing, and the research credit -- top the list of offsets to pay for rate cuts. These tax benefits, like the interest deduction, result in unequal effective tax rates across the corporate sector. Promotion of economic neutrality is a core principle of tax economics. From that principle, it follows that interest deductions have no special or protected status in the coming great debate about where to find the money to pay for corporate rate cuts.
This article has given no consideration to any costs of financial distress caused by high levels of corporate debt. If excessive corporate debt levels are considered potentially damaging to the economy -- in economic parlance, they impose negative externalities -- that would be another reason, in addition to the promotion of neutrality, for limiting interest deductions. [For more on this point, see Ruud A. de Mooij, "Tax Biases to Debt Finance: Assessing the Problem, Finding Solutions," IMF staff discussion note, May 3, 2011; and Joint Committee on Taxation, "Present Law and Background Relating to Tax Treatment of Business Debt," JCX-41-11 (July 11, 2011),]
And when politicians consider which corporate tax breaks to downsize to pay for a corporate rate cut, the possible negative externalities caused by debt give them a reason to prioritize limiting interest deductions. The economic case for limiting tax benefits with positive externalities, like those for research and alternative energy production, is much weaker than it is for limiting corporate interest deductions.