One of the hallmarks of sound 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 is neutrality: taxes should aim to raise revenue with a minimum of economic distortion, and should not attempt to micromanage the economy. Many income tax systems, however, including the system in the U.S., distort the business decision to use debt or equity financing for business investment by giving tax deductions for interest expenses associated with borrowing.
The government of Belgium is taking a novel approach to this problem. Starting next year, Belgian taxpayers will be able to take a notional interest deduction based on their equity. The deduction is calculated based on Belgium equity (defined as the total equity on the firm’s opening balance sheet calculated using GAAP principles) multiplied times that notional interest rate (defined as the annual average of the monthly published rates of the long term Belgian Government Bonds).
Brazil and New Zealand have provided similar benefits in the past, but not on the scale adopted by Belgium. Government officials from Belgium hope this deduction will neutralize the tax treatment of debt and equity and act as an incentive for firms to locate equity investment in Belgium. Combined with the recent reduction in Belgium’s 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. rate from 40 to 34 percent, these changes will certainly make Belgium a more competitive location for investment.
In the U.S., the Congressional Budget Office (CBO) recently estimated that the U.S. effective tax rate on debt-financed investment is -6.4 percent, while that on equity-financed investment is 36.1 percent. The President’s Advisory Panel on Tax Reform recommended an elimination of the interest deduction, which would (like the Belgian notional interest deduction) move the U.S. tax system toward more neutral treatment of debt and equity. We have more comments on this issue, and the Tax Reform Panel’s recommendations, here.
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