The May 16, 2015 cover story for Economist is “Tax-free debt: The great distortion.” The article advocates one of my personal pet ideas: eliminate tax deductions for home mortgage interest (see “Most perverse things about the U.S. tax code?” for example), though not for all of the reasons that I am against subsidizing home ownership, e.g., that it makes the labor market more rigid and exposes consumers to risks such as Detroit or Chicago becoming insolvent. The Economist goes farther, however, and suggests eliminating deductions for business interest. Could that work? Consider an equipment leasing company. After depreciation, interest would presumably be its largest expense. At current U.S. corporate income tax rates the enterprise would owe more in taxes than its actual cash earnings. Thus leasing companies couldn’t exist in their present form or with anything like their existing rates.
I can’t quite figure out if this makes sense as an economic policy. If interest is not deductible, doesn’t that favor the largest enterprises that can borrow at the lowest costs? So if you’re a mid-sized business trying to compete with General Electric, you’re now at a further disadvantage because GE can borrow at much lower cost than you and then offer favorable lease rates for its products, an effect magnified by the lack of deductibility for your higher payments. If interest is not deductible then incumbent companies with large capital bases will be further advantaged compared to startups? Supposedly there are economists at the Economist but I can’t figure out why interest, a necessary expenses for many types of businesses, should be treated differently than other types of business expense. (The home mortgage situation is different, I think, because that’s a personal expense and generally personal expenses are not deductible.)
[Separately, the research behind the article is a little suspect for saying “America’s debt subsidies cost the federal government over 2% of GDP—as much as it spends on all its policies to help the poor.” To the extent that you believe elaborate medical interventions “help the poor,” this is wrong. Federal Medicaid spending alone is close to 2% of GDP (gao.gov; this is not the total spent on Medicaid, I don’t think, because it excludes what states spend). How could the editors have missed the fact that the U.S. is a country with tens of millions of working-age residents who don’t work and yet who don’t lack for the essentials (housing, food, health care) and that this could not be consistent with only a few percent of GDP captured by the poverty industry?]
“How could the editors have missed” Because they are talking their own book / agenda / personal biases?
The underlying economic concept is that there is no reason for government to bias the choice of method for obtaining capital between equity and debt. The best economic results should result when the nature of the use for capital matches the risk characteristic of the financing. Government should remain neutral.
My approach to eliminating the bias would be to make dividends deductible in the same way that interest is deductible. This is a hard sell politically, but could actually end up relatively small revenue impact. On the direct tax side, dividends are extremely hard to hide, so the end recipient will pay taxes. The dividends would end up going mostly to the rich, the pension funds, and retirees. I don’t mind helping the finances of pension funds and retirees. Since this would be visible incremental income, the rich would pay the top tax rate, which is about twice the mean corporate rate.
There would also be a partial shift away from debt toward equity, which would reduce debt ratios and improve financial stability at many firms.
It might even reduce the pressure for crony capitalism handouts. If dividends are from pre-tax income, the stockholders and board wll be less interested in other tax advantaged schemes.
rjh: Thanks for that! You are much more cogent on this subject than the folks writing for the Economist!
IANAEconomist, but it isn’t clear to me that this would disadvantage *startups* specifically. If anything the debt/equity mix for startup financing would seem to lean more heavily toward equity than does financing for other firms. Of course it’s possible for established firms to issue new shares, but it seems less common.
Of course this would hurt the construction industry, but we’re making an omelet here. I agree with rjh that less debt would seem to make most firms more stable, but it’s not clear that the Economist would care about that.
It’s significant that The Economist is endorsing this concept. It may now go mainstream.
This is more of an issue for businesses than for individuals. Businesses get to choose how they obtain capital, and that decision is often driven by tax considerations. All the ways companies pay for capital – interest, dividends, and stock buybacks – should be taxed at the same rate. Right now, there’s a huge tax bias in favor of debt. Borrowing for stock buybacks is a huge fraction of US corporate borrowing, and it’s driven by tax considerations. That’s effectively a very expensive subsidy program.
Eliminating the tax benefits of debt has systemic advantages. When a company financed by equity goes under, its stockholders suffer, but the potential loss is bounded. As we learned in 2008, debt-financed failures cascade. Much M&A, private equity, and hedge fund activity is fuelled by the tax advantages of equity to debt conversion. Eliminate those, and much unnecessary financial activity goes away. The hedge fund industry will scream, but now that it’s well known that hedge funds underperform the market while extracting huge fees, that’s no big loss.
This change shouldn’t affect startup companies. Those are almost always equity funded. Nobody loans to a startup that will probably fail. (There are some startups with complex debt/equity/warrant deals which exist to get the tax benefits of debt with the potential upside of equity. That’s a tax gimmick, not lending.)
The overall effect is conservative. By removing a Government policy which distorts markets, we move back to a system where businesses are primarily equity-funded. It returns companies to their historical role as payers of dividends.
It’s a good time for this change to business financing. Interest rates are very low, so the tax impact is also low.
In Canada, interest on your mortgage is not deductible; but I think the Canadian real estate market is as nuts as the USA’s, so removing deductions may not be a silver bullet.
If home interest becomes non-deductible, while leaving business interest deductible, it would make sense to create a business to get a loan to purchase a home, where the interest is deductible, and then the person would rent the home from the business. The business could be something like a no-income REIT.