Addressing Poor Arguments Against the Interest Deduction
August 16, 2016
The tax reform proposal recently released by the House Republicans would be strongly pro-growth and greatly reduce income tax biases against saving and investment. The only major provision that would be inconsistent with a purely neutral tax is the elimination of the deductibility of business interest as a partial “pay-for.” (Please see the Tax Foundation analysis of the proposal at: https://taxfoundation.org/article/details-and-analysis-2016-house-republican-tax-reform-plan.)
There are two consistent ways to treat interest in an economically optimal tax system, one that does not discriminate against saving and investment. Either the interest should be deducted by the borrower and taxed to the lender; or the interest should not deductible by the borrower and not taxable income for the lender. In either case, a portion of the returns on an investment that is financed with borrowed money is subject to one layer of tax, paid by either the borrower or the lender but not both. Taxing the interest portion of the investment return on the borrower’s tax form by disallowing the deduction, and taxing it again when the lender receives it, is double taxation. This is akin to the double tax imposed on dividends or retained earnings of Schedule C-corporations (where, in addition to the corporate tax, the shareholders are taxed when the dividends are paid, or taxed later as retained earnings raise share prices and the shareholders take the resulting capital gains). This double taxation of C-corporations is one of the biases in the income tax against saving and investment.
Removing the deductibility of interest is sometimes advocated on two grounds. One is that is equalizes the tax treatment of debt-financed and equity-financed investment, eliminating a perceived distortion favoring “too much debt.” The other is that, if a tax plan allows full and immediate deduction of the cost of plant and equipment, and also allows the interest deduction, it seems to create a negative tax rate for the borrowing firm. Both rationales are in error.
Treating all sources of financing alike?
Businesses can be split into two groups for tax purposes: those whose returns on equity are taxed twice, and those whose returns on equity are taxed once. Earnings of schedule C-corporations are taxed twice, once at the corporate level, and again when the shareholders receive dividends or take capital gains. This double tax applies to equity-financed investment. By contrast, there is only one layer of tax on equity returns of other types of businesses, including Schedule S-corporations, partnerships, and proprietorships, which are collectively referred to as “pass-through” businesses. Their income is taxed once, when it reaches the owners; there is no second layer of tax at the business level. For both sectors, there is only one layer of tax on the portion of returns on debt financed investment that is passed through to lenders as taxable interest.
Removing the deduction for interest would eliminate the distinction between debt and equity finance for C-corporations. However, it would introduce a new distortion between debt financing and financing with a business’s own income for the entire pass-through sector. That sector currently generates half of all business income. Elimination of the interest deduction would be an enormous new distortion impeding capital formation. It would raise the cost of capital for the affected businesses, reduce returns to the owners, and discourage capital formation.
The fear that the current difference in taxation between debt and equity encourages “too much debt” is overblown. It applies only to the C-corporation sector, and firms’ ability to add debt is limited. As a corporation becomes more highly leveraged (adds more debt), lenders regard the firm as a riskier borrower, and raise the interest rate they charge the firm. The business refrains from adding new debt when the higher charges on the debt service exceed the cost of obtaining funds by issuing new equity. The problem is self-limiting, and of little economic consequence.
The real difficulty with the tax treatment of businesses is the added layer of corporate tax. Leveling the playing field in a pro-growth manner can be done by eliminating the tax at the corporate level or the shareholder level, resulting in one tax on corporate returns, not two. It should not be done by subjecting debt-financed investment to two layers of tax. Equalize down, not up. In that vein, the majority staff of the Senate Finance Committee is developing a proposal to allow corporations a deduction for dividends.
Negative tax rate argument.
Some critics of full and immediate expensing of the cost of capital equipment and buildings argue that it creates a subsidy in the case of an investment financed with borrowed money. They assert that it is necessary to deny businesses a deduction for interest expense if the business is permitted to immediately expense their capital outlays. In a blog post, Howard Gleckman of the Tax Policy Center made this argument, stating: “When a firm can expense its capital costs, the tax rate on that investment is zero. If the business can also deduct interest, it is paying a negative tax on that equipment – effectively receiving an investment subsidy from the government.”
The argument goes: “All profits are eventually competed away, so businesses only earn returns on their assets that are barely equal in value to the cost of the assets. Therefore, if a firm gets to deduct the full cost of the assets on its tax return, it will have zero reportable taxable income over the life of the investments, and pay no tax. That is OK if it buys the asset with its own (after-tax) money. But if it borrows money to buy the asset, and gets to deduct the interest, it will have a negative tax on the projects due to the interest deduction. So if we let the business deduct the entire cost of buying the asset, we should deny the business a deduction for the interest it pays on the borrowed money.”
There are glaring errors with this analysis.
The initial premise is wrong. Not all profits are competed away. Assuming that all profit is competed away is an unrealistic over-simplification popular among academics to facilitate their analysis. (An unfortunate habit in the profession, leading to many jokes. For example: An economist and a sailor are stranded on a desert island with a case of canned goods. “How can we get at the food?” asks the sailor. “Simple,” says the economist. “Assume a can opener.”)
In the real world, assets normally earn more than they cost in order to cover risk and to reward innovation. Expensing the cost of an asset does not wipe out taxable income, nor send taxes or tax rates to zero. There are several reasons why.
Producers with a particular edge will always earn out-sized profits (called “quasi-rents). The best agricultural land will always out-earn inferior plots. The best business locations will always generate higher rents that inferior locales.
In addition, innovation always keeps a large number of businesses ahead of the competition. A new and better product will yield unusually high returns until the competition can catch up. This is true in general, but is particularly obvious in the case of a patentable innovation. Patents issued to encourage innovation (the rationale explicitly set out for them in the Constitution) ensure that a significant net return on assets will always exist somewhere in the system. Even without patents, as long as innovation continues, some businesses will out-earn others.
Also, no rational business would borrow to buy an asset if there were no return left over after paying the bank or the bondholder. Profits can get pretty low in some industries, but the need to cover the basic time value of money, plus some reward for the work of managing the enterprise, plus a significant cushion for risk requires there to be some prospect of net income as the norm. The business takes the risk of not recovering the cost of the asset. A recession, a better product newly invented by a competitor, or a change in the buying habits of the public can wipe out any return to the investor. The investor must expect to be earning a net profit on the asset, even after paying the bank. On no account would a firm borrow to buy an asset expected to yield nothing more than the purchase price, because it would end up losing money on the interest. Only in the rarefied risk-free, effort-free world of the ivory tower could such an outcome be taken seriously.
The claim that the deduction of the interest payment by the borrowing business (in addition to the cost of the asset) creates too much of a deduction and creates a negative tax is wrong. It ignores the tax paid by the lender. It looks at only one side of the coin, as it were.
Where there is a borrower, there is also a lender. The lender is in league with the borrower to finance the purchase of the asset. The lender receives some of the return on the asset in the form of interest and pays tax on that portion. The borrower pays tax on the rest. None of the return on the asset is just dropped into oblivion. It is true that borrower deducts the interest payment, but the interest then becomes taxable income to the lender. Unless we stop taxing interest received by banks and bondholders, the deduction by the borrower does not reduce the tax base nor short-change the Treasury.
But what if the lender does not owe tax? Some interest is collected in tax deferred pensions and other types of retirement plans, and is not taxed immediately, but the government collects the tax at a later date, on an even larger amount of accumulated earnings as the reinvested savings build up and are paid out. Some small fraction of interest goes to tax exempt charities and colleges, but the decision not to tax those entities was made by the government, presumably for some good social policy reason, and it is those entities that are being subsidized, not the borrowers. Also, these donation-dependent entities have limited flexibility to alter their saving; they can only save what they are given, and the charities are required to distribute most of it each year. They cannot suddenly increase their investments, and therefore are not the marginal lenders who can step up with additional money to fund the growth of the capital stock.
Bottom line: growth is funded by taxable lenders or shareholders, and interest deducted by a borrowing business is taxable to those interest recipients. The interest rates in the credit markets are set by the marginal lenders, who are taxable, and who demand sufficient interest to cover the tax on the income. That some non-marginal lenders are tax exempt is no excuse for not allowing a business to deduct its tax-inclusive interest costs when it has to borrow at interest rates that are set in the taxable portion of the credit market.
For all these reasons, the argument that expensing produces negative tax rates on investment and constitutes a subsidy in the presence of interest deductions is flat wrong. There is no good reason to eliminate interest deductions to permit expensing. Expensing is a key element of any tax system which seeks to put all economic activity on a level playing field. Not expensing creates a tax distortion against saving and investment in favor of consumption. Not expensing understates costs and overstates profits from employing physical capital. Not expensing reduces labor productivity and reduces wages and employment. These are the tax distortions that matter. Adopting expensing and retaining the current tax treatment of interest would correct them.
 Assets generally earn at least a bare bones return, greater than zero, and often much more. Anything over the “bare bones” return is called “economic profit,” and it is that which economists often claim is competed away, eventually. But zero “economic profit” still leaves the bare bones return to be taxed. Expensing would offset much of the tax on a bare bones return on depreciable physical capital, but it would not protect returns to risk, land, intellectual property, or the many other sources of returns to a business.