Reducing the Tax Shield of Debt

As I wrote last week, there is broad bipartisan agreement that Congress must reduce the statutory tax rate on C corporations. However, politicians won’t find easy answers when it comes to paying for meaningful rate reduction. Ending subsidies to oil and gas companies or repealing the accelerated depreciation for corporate jets won’t make a real dent in the budget. Meanwhile, the largest tax expenditures in the corporate tax code effectively encourage capital investment, or Research & Development, just to name a few. Many of these breaks serve a reasonable economic purpose, and sizeable constituencies will fight their repeal.

Instead, Congress should closely examine the corporate tax code’s preference for debt financing, which arises because returns to debt (interest) are tax deductible, while returns to equity (dividends, or alternative uses of retained earnings) are not. According to a 2005 analysis by the CBO (see page 8, here), debt-financed investments face a negative 6.4% effective marginal tax rate, while equity investments are taxed at a 36.1% effective marginal tax rate.

This bias creates inefficiency most simply because it favors investments that can more naturally be financed with debt—such as equipment that can be easily offered as collateral. In turn, industries that use this type of investment more intensively (such as utilities) will face lower effective tax rates than those who rely on intangible capital more typically funded by equity (such as software companies). This favoritism misallocates capital throughout the economy.

Furthermore, excessive debt has a damaging external effect on the broader economy. In particular, increased leverage during an economic expansion (as in the 2001-2007 period) makes the ensuing recession more severe, according to a recent study by the National Bureau of Economic Research (NBER), which analyzed 14 advanced economies since 1870. This negative externality implies that the tax code should discourage the use of debt—or at the very least, treat it neutrally.

The simplest way to reduce the tax code’s bias for debt is for Congress to limit the interest deduction to a fixed percentage of total interest expense. Alex Brill of the American Enterprise Institute proposed a 90% limit (i.e., a corporation with $1 million in interest expense could claim a $900,000 deduction) as part of a broader reform; President Obama’s Economic Recovery Advisory Board put forth a similar proposal (see page 72, here), though exempting most small- and mid-sized businesses.  Personally, I would advocate a much lower cap, perhaps as low as 50%, which would virtually eliminate the tax code’s bias for debt.

It is difficult to make a specific revenue estimate for proposals such as these—the interest deduction is not a formal tax expenditure, so it is not rigorously estimated by government economists. However, public data on gross interest expense for C corporations suggest that a partial disallowance could raise a significant amount of revenue. In 2007 (the most recent year before the crisis), C corporations reported taxable income of $2.2 trillion. In the same year, C corporations also deducted $1.5 trillion in interest expense. Thus, Congress could significantly expand the corporate tax base by disallowing a portion of the interest deduction.

In short, Congress will find it impossible to meaningfully broaden the corporate tax base by eliminating easy political targets, such as wasteful tax expenditures. Instead, Congress should focus on reducing the tax code’s bias towards debt, which could pay for a large reduction in the corporate tax rate. Reducing this bias makes good economic sense; the current system misallocates resources and saddles the macroeconomy with excess leverage, increasing the severity of recessions. Rather than encourage leverage by allowing full deductibility of interest, Congress should reform the tax code to put debt and equity on a level footing.

Bob Pozen is a Senior Lecturer at Harvard Business School and a Senior Fellow at the Brookings Institution. His latest book, Extreme Productivity, is now available at your favorite local or online bookstore.

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