A Recipe for Cutting Corporate Taxes

Amid all the division on Capitol Hill, both parties generally agree that the corporate tax rate, which at 35 percent is among the highest in the world, needs to be cut. During Wednesday’s presidential debate, both candidates advocated a significant reduction in the corporate tax rate.

Yet the federal budget’s unsustainable fiscal path should preclude a large unfunded tax cut. Given these competing demands, policymakers have been searching for revenue-neutral reforms that reduce the corporate tax rate and broaden the corporate tax base.

Few politicians have offered sufficient details about how they would pay for a reduction in the corporate tax rate. Politically vulnerable tax breaks, such as special treatment of corporate jets and “green” energy, are small relative to total corporate tax receipts. And large tax breaks, such as those for research and development, are considered essential to economic growth.

So if Congress wants to finance a meaningful reduction of the corporate tax rate, it will need to find other base-broadening measures that meet two criteria: a solid policy rationale, and the potential for significant new revenue. Fortunately, there is a base-broadening reform that fits both: limiting corporate interest deductions. Democrats, including President Obama, and Republicans, including House Ways and Means Committee Chairman Dave Camp (R-Mich.), have suggested that Congress seriously consider such an approach.

Currently, when a corporation pays interest, it may deduct that interest on its tax return. By contrast, a corporation may not deduct its dividend payments to shareholders. This bias distorts the financing decisions of corporate managers, who might choose, solely for tax reasons, to finance a certain project with debt instead of equity. This bias also distorts investment decisions in favor of easily collateralized equipment suitable for debt finance, at the expense of investments better suited for equity finance, such as capital-raising by small business.

The tax code’s bias for debt is even more worrying, because excess leverage often imposes costs on external parties other than the debt issuer. For instance, a highly indebted company is more likely to go bankrupt, which can seriously harm its employees, customers and suppliers. Companies are unlikely to fully consider those external costs when deciding how much debt to take on.

Furthermore, reforming the treatment of interest expenses can raise a large amount of revenue and thus pay for a significant reduction of the corporate tax rate. In 2007, corporations with net income paid $294 billion in corporate taxes and claimed $1.37 trillion in gross interest deductions, according to the Internal Revenue Service.

I estimate that from 2000 to 2009 — the most recent years with relevant data — a reduction of the corporate tax rate from 35 percent to 25 percent could have been financed solely by disallowing the deductibility of roughly 30 percent of corporations’ gross interest expenses — that is, by allowing corporations to deduct only 70 percent of their gross interest expenses, rather than 100 percent, as they can now. Although this would increase the effective tax rate on debt-financed investment, the overall cost of capital would remain roughly the same because equity returns would be taxed at 25 percent instead of 35 percent.

Looking forward, our revenue estimates would have to take into account the lower interest rates and lower corporate leverage expected over the next decade. Also, debt issued by the financial sector is likely to need special treatment, because the profits of a financial institution depend largely on the spread between the interest rates at which they borrow and the rates at which they lend.

That is not to say that the financial sector should be exempt from this reform. Excess leverage increases the odds that a financial institution can fail. And as the 2008 financial crisis vividly demonstrated, the failure of one financial firm can damage other firms, governmental entities and the economy as a whole. While regulators are trying to adopt measures to make the financial system more stable, tax subsidies for leverage in the financial sector have the opposite effect.

In short, modifications to the treatment of corporate interest expense should be a key component of bipartisan corporate tax reform. Such a restriction could finance a significant reduction in the corporate tax rate and greatly reduce the tax code’s implicit subsidy to debt-financed investment. This would make the United States a more competitive place to do business, reduce distortions in corporate decision-making and help foster a more stable financial system.