Interest Deductibility Issues and Reforms

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Tax reform discussions this year have often debated the “border adjustment” proposed by the House GOP, but an equally important reform option is to limit the interest deductibility. Current proposals to lower corporate and individual income tax rates will cost the federal government a substantial amount of revenue, and Tax Foundation Economist Alan Cole explains in a new research paper that limiting interest deductibility could help in the enactment of meaningful tax reform.

Cole’s research explains the policy rationale for keeping the interest deduction as is, but questions whether the tax code should favor debt over equity.

“It is easy to make arguments for interest deductibility. If interest is income (and by most popular definitions, it is), then interest payments are negative income and it makes sense to deduct them. If debt finance contributes to investments that boost productivity and wages (and it does), then adding a tax burden to debt finance will harm economic growth.

“But it is also quite possible to make arguments against interest deductibility, and a number of strong arguments have been made over the years. Interest deductibility creates holes in the tax base, both domestically and internationally. It distorts corporate investment strategies and increases the returns to financial engineering. And it contributes to a potentially dangerous macroeconomic environment of overleveraging.”

Key Findings:

  • Overall, the U.S. federal income tax system is intended to include deductions for interest paid and taxation on interest received. However, a substantial portion of interest received is untaxed.
  • The combination of deductions for interest paid and untaxed interest income results in a substantial gap in the income tax, amounting to as much as 33 percent of all corporate debt.
  • Interest deductibility is also a key feature of many profit-shifting arrangements, where multinational corporations borrow in order to reduce U.S. taxable income against the high U.S. corporate income tax rate.
  • The net subsidy for leverage created by interest deductibility may contribute to financial crises because unexpected defaults on debts often lead to a macroeconomic cascade of troubled financial assets.
  • Several reforms have sought to limit interest deductibility in recent years, and these reforms should be taken seriously.
  • Tax provisions should be evaluated on the basis of opportunity cost; limiting interest deductibility is a better idea to raise revenue than many other options.

The Tax Foundation is the nation’s leading independent tax policy research organization. Since 1937, our principled research, insightful analysis, and engaged experts have informed smarter tax policy at the federal, state, and local levels.

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