Reducing tax rates by reducing tax bias

Editor’s note: This post originally appeared in Real Clear Markets on June 23, 2015.

Tax experts from around the world gathered two weeks ago in Washington DC to push forward a Euro-led project for the prevention of BEPS — base erosion and profit shifting. This project is aimed at getting multinational companies to locate facilities and jobs in real countries, instead of post office boxes in tax havens.    

The corporate tax rates in Europe are already 10% to 15% lower than the 35% rate in the U.S. If Europe moves forward with BEPS, that will put more pressure on US large companies to move people and plants abroad — unless Congress substantially reduces the U.S. corporate tax rate.

While almost everyone wants to reduce the U.S. corporate tax from 35% to 25%, almost no industry is willing to give up its current tax preferences to achieve this rate reduction on a revenue neutral basis. This means that the national debt would not rise because revenues lost by rate reduction would be offset by revenues gained by restricting existing tax preferences.   

Therefore, Congress should finance a substantial lowering of the U.S. corporate tax rate largely by reducing the tremendous bias in the current tax code for debt and against equity. Most importantly, companies may deduct interest paid on all their debt, but may not deduct any dividends paid on their shares. As a result, the effective tax rate on corporate debt is negative 6.4%, as compared to positive 35% for corporate equity, according to the Congressional Budget Office.

This tax bias for debt has major negative implications for the US economy. To begin with, this bias strongly encourages financial institutions and other firms to maximize their leverage — their debt relative to their equity. High leverage increases the risk of bankruptcy and magnifies any financial crisis because a business under pressure has little equity cushion to absorb losses.

The tax bias against equity makes it much more expensive for small businesses and knowledge-based companies to raise capital. Because they do not have the hard assets sought by banks to collateralize loans, such companies are forced to sell large chunks of their equity.

More generally, the tax bias against equity and for debt leads to substantial distortions in how projects are financed. Optimally, a company would choose the most suitable form of financing for each project based on its economic features, not tax benefits. But the huge difference in effective tax rates pushes companies to finance projects with debt rather than equity whenever feasible.

One way to remedy this imbalance would be to allow companies to deduct dividends on equity as well as interest on debt. However, this remedy would mean a significant loss of tax revenue for the Treasury and an even higher national debt.

Alternatively, Congress could limit the interest deductions of companies — for example, to 65% of the interest they pay on their debt. I have calculated that, during the years 2000 to 2009, such a limit would have increased tax revenue by enough to reduce the corporate income tax rate from 35% to 25% on a revenue neutral basis. Although predictions about the next 10 years are inherently imprecise, I would forecast that a 65% limit on corporate interest deductions could, alone, finance a reduction in the corporate income tax rate to 25% to 28%.  

What would be the main questions and responses to a 65% limit on interest deductions for corporations?

1. Would the sudden imposition of such a limit be disruptive to corporate borrowers and bond investors?

This legitimate objection should be met by a gradual phasing in of the limit. For example, Congress might allow a full deduction of interest on outstanding bonds, and then reduce the deduction limit gradually from 100% to 65% over several years.  

2. Would the 65% limit on interest deductions increase the effective cost of capital for US corporations?

No, on average the cost of raising capital would be the same — because the 65% limit on corporate interest deductions would be offset by the reduction in the corporate tax rate from 35% to 25%. To take a simple example, suppose a company had pre-tax income of $339 and paid $60 of interest on its debt. It would deduct $21 less — $39 of interest instead of $60 — but would benefit more by a 10% rate reduction on $300 in taxable income (after the $39 deduction).

3. Despite this same result, on average wouldn’t some corporations be in a better position, and others in a worse position, if Congress adopted the 65% limit on interest deductions and reduced the corporate tax rate from 35% to 25%?

Yes, there would be winners and losers depending on how much debt a corporation had incurred. Companies with relatively low levels of corporate debt would be left with more after-tax income, while companies with relatively high levels of debt would wind up with less after-tax income.

In specific, corporations with interest deductions exceeding 50% of their pre-tax income would be in a worse position. But this is the type of corporation that poses a substantial risk of bankruptcy, especially in times of financial crisis.

4.   Would the 65% limit on interest deductions lead business executives to switch their legal format from a corporation to a pass-through entity like a partnership?

This incentive to switch would result if the 65% limit were applied only to corporations. However, this result could be avoided if this 65% limit were applied to the debts of all businesses, regardless of their legal format.

Moreover, if the 65% limit on interest deductions were used to reduce the corporate rate from 35% to 25%, as I propose, this combination would mitigate the current disadvantage of double taxation (at the corporate and shareholder levels) of corporations. Thus, this combination would reduce the current incentives for businesses to switch from corporations to pass-through entities like partnerships.

5. Would the proposed 65% limit on interest deductions lead to higher cost loans if applied to banks?

Yes. This is an area where the proposal’s impact on one industry would have adverse implications for the US economy. If banks have lower after-tax returns on their deposits, they are likely to charge higher interest rates on their loans.

In addition, banks would argue that their deposits should have a better tax treatment than other debt instruments because most bank deposits are insured by the FDIC and therefore not as risky. For both these reasons, I would modify my proposal to allow banks to deduct 80% to 90% of the interest they pay on FDIC-insured deposits.

Of course, these modifications to my original proposal — gradual phasing in the 65% limit, and allowing banks to deduct more interest on bank deposits — would mean fewer taxes to support a revenue-neutral reduction in the corporate tax rate. Similarly, less tax revenue would be generated if Congress decided it was politically more acceptable to allow small businesses to deduct 100% of their initial $100,000 in interest payments and 65% thereafter.

Nevertheless, any reasonable set of limits on interest deductions by corporations can finance a significant reduction in the corporate tax rate, while mitigating the tax code’s current bias for debt and against equity. To fill the gap left by any legislative compromises on interest deductions, Congress would have to enact other forms of corporate tax reform to bring the corporate rate down to 25%.