How should taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. policy treat interest expenses? Historically, corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. systems in the U.S. and around the world have allowed businesses to deduct their interest paid. As Congress contemplates adding a new worldwide interest limitation rule as part of the Build Back Better Act (BBBA), it is useful to consider the potential effects of this proposal as well as whether it is necessary to add this on top of the U.S.’s existing restrictions on the value of interest deductions.
Interest deductibility reduces the cost of investment, increasing business investment and the capital stock, but it also creates a bias toward debt financing. The resulting higher leverage contributes to bankruptcy risk and potentially to business cycle severity. Moreover, multinationals can strategically locate more borrowing in high-tax countries as a means of profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. , although the relative importance of this channel is unclear.
In light of this trade-off, many countries have adopted “thin-capitalization” rules, which typically limit the net interest deduction to 30 percent of earnings before interest, taxes, depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. and amortization (EBITDA). These rules reduce the tax advantage of debt for highly leveraged firms or for multinationals with highly leveraged subsidiaries.
The U.S. adopted this approach in 2017 as part of the Tax Cuts and Jobs Act (TCJA)The Tax Cuts and Jobs Act in 2017 overhauled the federal tax code by reforming individual and business taxes. It was pro-growth reform, significantly lowering marginal tax rates and cost of capital. We estimated it reduced federal revenue by .47 trillion over 10 years before accounting for economic growth. ; the new section 163(j) thin-capitalization rule limited the net interest deduction to 30 percent of EBITDA, consistent with the approach in other countries. However, this limitation is set to go beyond other countries beginning in 2022 by tightening to 30 percent of earnings before interest and taxes (EBIT), allowing a smaller deduction than under current policy.
In addition to the new thin-capitalization rule, the U.S. has interest expense allocation rules to further limit the value of interest deductions. Indirect expense allocation requires that multinationals attribute part of their domestic expenses (interest, research and development, and stewardship) to their foreign income—including taxable foreign income and exempt foreign income. The portion allocated to taxable foreign income can reduce the value of foreign tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s.
Over the last few months, the Biden administration and congressional Democrats have introduced various proposals to further limit interest deductions to raise revenue. As part of its Green Book, the administration proposed to apply section 265 denial of deductions to exempt foreign income, requiring that expenses allocated to these categories of exempt income be added back to U.S. taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . The most recent version of the Build Back Better Act instead exempts GILTI from expense allocation and adds a new worldwide interest limitation. This worldwide interest limitation, the section 163(n) rules, would apportion a multinational’s worldwide net interest expense into domestic and foreign baskets based on the domestic and foreign shares of the multinational’s worldwide EBITDA. The multinational’s domestic net interest expense would then be limited to 110 percent of this apportioned amount.
Both proposals to tighten interest limitations would apply in addition to the existing thin-capitalization rules for U.S. multinationals, going well beyond the policies adopted in other countries.
While these proposals are intended to address overborrowing in the U.S. by multinationals, it’s not clear that this remains a problem. The tax advantage of borrowing heavily in the U.S. is much smaller now than historically, thanks to a 21 percent corporate tax rate comparable to other developed nations and to the TCJA’s thin-capitalization rules.
We explore the implications of these proposals using Tax Foundation’s Multinational Tax Model. Table 1 reports the revenue effects of four policies that impact the value of interest deductions: keeping EBITDA in the 163(j) thin-capitalization rules instead of switching to EBIT; adding the worldwide interest limitation as section 163(n); adding 163(n) but exempting GILTI from expense allocation, as in the current version of the BBB; and applying section 265 denial of deductions as in the administration’s proposal. For comparability, we have all of these take effect in 2023 as in the BBB Act.
|Billions of U.S. dollars, over the current budget window|
|Keep EBITDA in 163(j)||-8.7||-7.5||-8.0||-8.2||-8.5||-8.7||-9.0||-9.2||-9.4||-77.3|
|Add 163(n), exempt GILTI from expense allocation||3.0||3.2||3.5||3.9||4.0||4.1||4.2||4.3||4.5||34.7|
|Sec. 265 denial of deductions||6.9||7.4||7.9||7.0||7.3||7.5||7.7||7.9||8.1||67.5|
Notes: This table presents the change in federal corporate income tax liabilities of U.S. multinationals in billions of dollars for each provision. All estimates are static, with no behavioral responses.
Source: Tax Foundation’s Multinational Tax Model.
Retaining the use of EBITDA instead of EBIT in the thin-capitalization rules (163(j)) would reduce the federal corporate income tax liabilities of U.S. multinationals by $77.3 billion over the budget window. Adding the new worldwide interest limitation would raise these liabilities by $47.3 billion. However, pairing the worldwide interest limitation with exempting GILTI from expense allocation—as in the BBB—raises these liabilities by $34.7 billion. Using the administration’s proposed denial of deductions under section 265 would have increased these liabilities by $67.5 billion over the budget window. Note that these estimates are static, and do not include behavioral responses to these tax changes, or interactions with other types of economic activity (such as investment). This is useful for comparing the relative impacts of different limitations; the potential responses and economic effects are discussed below.
The aggregate results above demonstrate that the already-scheduled switch from EBITDA to EBIT in the thin-capitalization rules are more onerous than the newly proposed worldwide interest limitation and are somewhat more onerous than the administration’s proposed denial of deductions. However, the impacts of these different policies vary drastically by industry. Table 2 reports the change in federal corporate income tax liabilities of U.S. multinationals by industry for 2023, under each of these four policy changes.
|Millions of U.S. dollars|
|Industry||Keep EBITDA||Add 163(n)||Exchange 163(n)||Sec 265|
|Oil and gas extraction, coal mining||-8.5||301.3||301.3||85.9|
|All other mining||-373.7||0.0||0.0||22.8|
|Beverage and tobacco products||0.0||356.5||344.7||114.7|
|Petroleum and coal products manufacturing||-429.2||0.0||0.0||7.3|
|Pharmaceutical and medicine manufacturing||-80.0||851.6||676.4||644.1|
|Other chemical manufacturing||0.0||264.4||79.4||464.9|
|Plastics and rubber products manufacturing||-81.6||35.3||21.8||36.0|
|Nonmetallic mineral product manufacturing||-40.5||0.3||0.3||8.1|
|Primary metal manufacturing||-271.8||0.0||0.0||16.2|
|Fabricated metal products||-352.0||0.0||-48.9||114.4|
|Computer and electronic product manufacturing||0.0||369.8||323.4||769.8|
|Electrical equipment, appliance and component manufacturing||-838.0||0.0||-4.2||82.5|
|Motor vehicles and related manufacturing||0.0||0.0||-50.9||140.3|
|Other transportation equipment manufacturing||0.0||0.0||-23.1||44.9|
|Machinery, equipment, and supplies||0.0||39.0||28.4||48.5|
|Other miscellaneous durable goods||0.0||130.6||110.4||137.5|
|Drugs, chemicals, and allied products||0.0||65.2||64.4||9.9|
|Groceries and related products||0.0||0.0||-7.7||23.9|
|Other miscellaneous nondurable goods||0.0||37.7||-7.3||126.5|
|Transportation and warehousing||0.0||0.0||0.0||17.4|
|Publishing (except internet)||0.0||159.1||94.4||157.2|
|Motion picture and sound recording||0.0||4.5||-0.3||11.2|
|Finance and insurance|
|Nondepository credit intermediation||0.0||0.0||-18.6||65.3|
|Securities, commodity contracts, and other financial investments||0.0||0.0||-23.9||116.3|
|All other finance industries||0.0||0.0||-0.2||2.1|
|Insurance and related activities||0.0||0.0||-5.5||29.8|
|Real estate and rental and leasing||0.0||138.2||133.8||24.4|
|Professional, scientific, and technical services||0.0||611.0||554.5||277.4|
|Management of holding companies||-4229.4||27.9||-117.2||2580.7|
|Administrative and support and waste management and remediation||0.0||85.6||83.6||11.3|
|Arts, entertainment, and recreation||0.0||0.0||0.0||9.4|
|Accommodation and food services||-120.9||138.5||132.6||21.2|
Notes: This table presents the change in federal corporate income tax liabilities of U.S. multinationals in millions of dollars for each provision in 2023. All estimates are static, with no behavioral responses. Major industries are in bold.
Source: Tax Foundation’s Multinational Tax Model.
The impacts of the switch to EBIT and of the worldwide interest limitation vary widely across industries, with many industries unaffected and others bearing more concentrated tax burdens. While the section 265 denial of deductions would impact every industry, the industries most affected by this policy are also among those most affected by the worldwide interest limitation.
The results shown above omit behavioral responses to these policies. While this omission elucidates which industries would be most impacted, Congress should consider how firms may respond to these incentives and the resulting economic implications. Multinationals may reduce their borrowing or shift more of their borrowing to foreign countries. The responsiveness of firms to these policies may vary widely depending on each firm’s specific circumstances. Some may be able to easily shift to borrowing in their affiliates in the United Kingdom or in Europe, while multinationals with less access to well-developed foreign financial markets may simply reduce their borrowing in response to these policies. Because these policy changes are either uncommon in other countries (thin-capitalization rules using EBIT instead of EBITDA) or unprecedented (worldwide interest limitations in addition to thin-capitalization rules, or section 265), the potential magnitudes of these responses are unclear.
Regardless of these debt responses, limitations on interest deductibility would raise the cost of financing for U.S. multinationals, reducing their investment. To counter this effect, proposals to limit interest deductions have often been paired with expansions of investment incentives, such as an allowance for corporate equity or immediate expensing of investment to provide full cost recovery. The TCJA took this approach, with bonus depreciationBonus depreciation allows firms to deduct a larger portion of certain “short-lived” investments in new or improved technology, equipment, or buildings, in the first year. Allowing businesses to write off more investments partially alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. for investment more than offsetting the impact of the thin-capitalization rule, although it made the bonus depreciation temporary and the thin-capitalization rule permanent.
Congress should carefully consider the goals and economic effects of interest limitations. While reducing the tax advantage of debt is a potentially worthy goal, it is unclear that piling further interest limitations on top of our existing limitations will advance this. It will certainly make the tax code even more complicated and difficult to comply with and administer.
December 17th update: An updated version of the Build Back Better plan modifies the proposed worldwide interest limitation by allowing firms to apportion their interest expense using the domestic and foreign shares of their worldwide assets instead of earnings before interest, taxes, depreciation and amortization (EBITDA). The analysis above refers to the House Build Back Better Act originally passed on November 19th.