To Owe or Be Owned—Depends on How You Tax It

In February, President Obama said “Companies are taxed heavily for making investments with equity; yet the tax code actually pays companies to invest using leverage”. And he is right: the corporate tax code in the United States creates a significant bias toward debt finance over equity.

Of course, the U.S. is not unique. In most of Europe, Asia and elsewhere in the world, the tax advantages of debt finance are even bigger than in the U.S.

The crux of the issue is that interest paid on borrowing can be deducted from the corporate tax bill, while returns paid on equity—dividends and capital gains—cannot.

The debt distortion is not new. What is new, however, is that we have come to realize that excessive debt (or leverage) is much more costly than we have always thought.

The global financial crisis was a stark lesson that excessive leverage ratios in financial institutions can create massive spillover effects to the rest of the economy or even beyond national borders.

Financial distortions have grown larger in recent years.

  • Indeed, firms respond more aggressively to the tax bias of debt. For example, innovation in financial products has blurred the distinction between debt and equity, creating ample opportunities for tax avoidance.
  • And multinational firms are increasingly reallocating debt and equity between countries to exploit the most favorable tax environments, thus eroding corporate tax bases. Arguably, this matters more when the public purses in advanced economies are under added strain.

It would actually make much more sense to tax-penalize debt than to tax-favor it. But that’s not what corporate tax codes do.

A recent IMF Staff Discussion Note offers two alternatives to the current corporate tax code. In a nutshell, it will require either reducing the tax deductibility of interest or introducing similar deductions for equity returns. Both reduce or eliminate the more favorable tax treatment of debt.

The first is to restrict or eliminate the deductibility of interest for corporate profits. That would broaden the corporate tax base and free up revenue for reductions in the rate. Many advanced countries nowadays pursue such a policy of restrictions on interest deductibility. The problem with restrictions, rather than eliminating deductibility altogether, is that the rules become very complex and firms find their way around them. Added to that, these measures make investment more expensive and tend to hurt economic growth. That is not a desirable long-term prospect.

The alternative then is to allow a deduction for normal equity returns. That is, a deduction for the value of returns on equity based on, say, the long-term government bond rate. The traditional allowance for interest deductions would remain, but the debt-equity playing field would be leveled. The flip side of eliminating incentives for excessive debt finance, is removing the bias against equity investments, with likely favorable implications for promoting investment, economic growth and job creation. Indeed, estimates suggest the reform can raise GDP by some 3 percent. Some countries—namely, Belgium, Brazil and Latvia—have had some success in this regard, moving toward such systems during the last decade.

The allowance for corporate equity deserves serious consideration from policymakers across the globe. Some governments may be understandably reluctant to introduce an allowance that will narrow the corporate tax base in the short run.

But designing a better system will ultimately pay off.

  • The loss of revenue can be kept to a minimum by granting the allowance only to new investment.
  • Improved tax design will make economies less vulnerable to future financial crises, and thus prevent enormous costs in terms of lost revenue.
  • And it could ultimately broaden corporate tax bases by eliminating the ample distortions the current systems create.

It’s time for change—end the debt bias in corporate income tax.

This post originally appeared at iMFdirect and is reproduced here with permission.