A Plan for Tackling Corporate Debt Bias

by Reihan Salam

Back in 2009, James Surowiecki of The New Yorker argued that the “debt bias” in the tax code exacerbates economic volatility:

Economies work best, generally speaking, when people are making decisions based on economic fundamentals, not on tax considerations. So, as much as possible, the tax system should be neutral between debt and equity, and between housing and other investments. It’s not, and, worse still, as we’ve seen in the past couple of years, debt magnifies risk: if companies or individuals rely on large amounts of leverage, it’s much easier for bad decisions to lead to insolvency, with significant ripple effects in the wider economy. A debt-ridden economy is inherently more fragile and more volatile. This doesn’t mean that the tax system caused the financial crisis; after all, the tax breaks have been around for a long time, and the crisis is new. But, as a recent I.M.F. study found, tax distortions likely made the total amount of debt that people and companies took on much bigger. And that made the bursting of the housing bubble especially damaging. So encouraging people to take on debt qualifies as a genuinely bad idea.

And recently, John Plender, a columnist for the Financial Times, made the case that the fiscal and regulatory bias against equity found in most of the big market democracies could have negative consequences for global growth, drawing on a new report from the Group of Thirty (“Long-Term Finance and Economic Growth“). To address this anti-equity bias, the report suggests a revenue-neutral effort to either eliminate the tax deductibility of interest payments while cutting the marginal tax rate for corporations or extending tax deductibility to equity dividends while hiking the marginal tax rate.

This discussion brought to mind Robert Pozen’s corporate tax reform proposal, which he recently summarized for International Tax Review:

To begin with, let me summarise the specifics of my proposal, which I detailed in Tax Notes. My proposal would reduce the US corporate tax rate from 35% to 25%. I would finance such a rate reduction by limiting deductions for the gross interest expense of corporations (I call this provision the “interest cap”). Nonfinancial corporations would be allowed to deduct 65% of their gross interest expense, while financial corporations would be allowed to deduct 7 9% of their gross interest expense. There would also be special rules for corporations that would have reported a loss for tax purposes, but for these restrictions on interest deductions.

My piece in Tax Notes was not intended to set a specific proposal in stone, but rather to illustrate the general strategy : reducing the corporate tax rate while limiting interest deductions. I believe that such a combination would reduce the tax code’s bias in favor of debt, while making the US a more attractive location for discrete, profitable investment projects.

I hope conservative tax reformers, including Rep. Dave Camp, are paying close attention to Pozen’s proposal.