The Corner

Economy & Business

Why the Tax Reform’s Limits on Corporate Interest Deductibility Were a Good Idea

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The Tax Cuts and Jobs Act is increasingly popular with the American public, and Republicans in Congress are desperately hoping that good vibes about the bill will save their majorities. I can’t say I’m a fan of the legislation as a whole, not least because I don’t think it will do enough to lift the after-tax incomes of low- and middle-income households. But in the spirit of giving credit where credit is due, I should point out at least one of the TCJA’s good points. Consider the limits that the legislation places on corporate interest deductibility, which according to Alan Cole writing in American Affairs, could change the way companies in the United States do business and make the U.S. economy more stable. Reducing the tax-deductibility of interest expenses has been a pet cause of mine for a while, so this strikes me as very good news.

By stipulating that companies cannot use the interest deduction to reduce their earnings by more than 30 percent, the law made taking on debt somewhat less attractive compared to seeking financing by offering equity to investors. It was high time for such a rebalancing; in the battle between debt and equity, Cole argues, debt has long had the upper hand. For one, it can seem less risky, because the amount owed is fixed from the start. It does not increase if a company does very well. Further, thanks to interest deductions, it has been cheaper to carry. Payments on interest for debt are deductible from taxes whereas equity payments — share buybacks and dividends — are not.

Taking on debt has therefore been a convenient way to decrease a firm’s taxes, which might be a good thing for business but is bad for the government: “A firm that chooses a more leveraged capital structure primarily to reduce its taxes is simply creating private returns at public expense,” Cole writes. “Each dollar saved through interest deductibility is a dollar lost for the government.” It can be bad for the economy as well, as everyone discovered during the 2008 financial crisis. Even after the crisis, in 2014, the Congressional Budget Office found that although most businesses had positive tax rates, the tax rate on debt was effectively negative.

Of course, equity has its downsides. It does little to discipline company managers as debt obligations do. Without the need to pay back a specific amount with interest, corporations may use the money to benefit themselves rather than the company. Still, argues Cole, equity is more flexible in times of crisis than debt, which means that problems are less likely to spiral out of control.

The prospect of a tax system less balanced in favor of debt is cheering for Cole, and it should be cheering for the rest of us, too, including those who have other gripes about the TCJA. “Even those most pessimistic about our current political moment can take heart,” he concludes, “policymakers can indeed learn from the mistakes of the past and make genuine attempts to fix them.”

Reihan Salam is president of the Manhattan Institute and a contributing editor of National Review.

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