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US tax reform: Reducing the tax code’s bias for debt

18 February 2013

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In January, International Tax Review’s Matthew Gilleard reported on some reactions to a corporate tax reform proposal forwarded by Robert Pozen, senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution, which would reduce the US corporate tax rate by limiting interest deductions. Here, Pozen responds to some of those objections.

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"). Non-financial corporations would be allowed to deduct 65% of their gross interest expense, while financial corporations would be allowed to deduct 79% 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.

With that said, let me address the main objections to my proposal.

Winners and losers

The most common objection to my proposal is that it would create winners and losers. While that objection is true, it is true because my proposal would substantially correct a significant distortion within the tax code in favour of debt finance. As a result, some corporations that are taking advantage of this bias in the tax code might see a higher tax burden under my proposal.

However, any revenue-neutral tax reform is mathematically guaranteed to create winners and losers. So, in my view, the primary criterion for evaluating a tax reform proposal should be whether it would reduce economic distortions.

I believe that my proposal would meet this criterion by moving the tax code closer to a neutral position between debt- and equity-finance. Under my proposal, corporations would no longer issue debt mainly because interest payments are deductible and returns to equity (dividends or share appreciation) are not. This means that corporations would make financing decisions for economic reasons rather than tax reasons-leading to a more efficient allocation of resources.

Transition relief

Other commentators in the International Tax Review article objected to the idea of applying the interest cap to pre-existing debt. I share this concern: corporations have made decisions about issuing debt based on good faith beliefs that the current treatment would continue.

I had been hesitant to allow for a broad grandfathering of existing debt. If the tax reform legislation allowed such grandfathering-effective on the enactment of the legislation-then corporations could rush to issue long-maturity debt shortly before the enactment of the legislation. In my piece, I proposed instead a 10-year, linear phase-in of rate reductions and restrictions to interest deductions.

However, I would accept an alternative approach: grandfathering existing debt effective as of January 1 of the year in which the legislation was first introduced (rather than at the date of enactment). That could substantially reduce any rush to issue debt shortly before the enactment of the legislation. The corporate tax rate could then be gradually reduced in a revenue-neutral manner.

Net interest versus gross interest

Observers frequently argue that my interest cap should apply solely to net interest expense, rather than gross interest expense. I disagree for two reasons.

First, applying the interest cap to net interest expense would raise only a small amount of revenue-enough to finance a reduction in the corporate tax rate by about 1.5 percentage points, based on estimates by the Congressional Research Service. As a result, the US corporate tax rate could not be reduced to a level competitive with most industrialised countries.

Second, restricting net interest deductions would (by itself) increase effective marginal tax rates (EMTRs) on debt-financed investment to nearly the same extent as restricting gross interest deductions (though average tax rates on debt-financed investment would be substantially different).

Consider a hypothetical non-financial corporation that has $300 million in gross interest income and $500 million in gross interest expense. Imagine it is considering a marginal investment that would cause it to incur an additional dollar in interest expense. Under my proposal, that corporation could deduct 65 cents of that additional dollar. If I instead applied the restrictions to net interest expense, that corporation could still deduct 65 cents of that additional dollar. This corporation's incentives-on the margin-essentially do not depend on whether the interest cap applies to net or gross interest expense.

Yet, as mentioned above, applying the interest cap to gross interest raises much more revenue, and thus can finance a much more significant reduction in the corporate tax rate. The reduced corporate tax rate mitigates the increase of EMTR on debt-financed investment and sharply reduces the EMTR on equity-financed investment. According to the model developed by the Congressional Budget Office, the average EMTR facing non-financial corporations would be roughly unchanged under my proposal.

By contrast, applying the interest cap to net interest expense could not finance a reduction in the corporate tax rate sufficient to offset the increase in EMTR associated with the interest cap. Thus, financing a corporate tax rate reduction by restricting net interest expense would cause the average EMTR facing corporate investment to increase.

Alternative approaches

Lastly, some commentators argue that we should reduce the distortions to financing decisions by cutting shareholder-level taxes on dividends and capital gains, rather than imposing an interest cap. While there are many good reasons to support lower dividend and capital gains taxes, such tax relief would in fact work against the goal of raising revenue to reduce the corporate tax rate. If corporate executives wish to reduce shareholder-level taxation, then they must put forward specific revenue or spending proposals to offset the revenue loss.

In fact, though most corporate executives want a 25% corporate tax rate, they have not been willing to eliminate or restrict the large tax preferences built into the tax code-such as the deduction for domestic production activities and the research and development credit. The items usually identified for repeal-such as accelerated depreciation for corporate jets or credits for green energy-are too small to finance any meaningful reduction of the corporate tax rate.

In these times of tight budgets, any proposal for tax reform must be at least revenue-neutral. And while I support "comprehensive" tax reform, this seems to be a long-shot.

A continuing process

I want to thank International Tax Review for giving me the opportunity to respond to the earlier article. But it is equally important to thank all those who commented on my proposal for that article. The thoughtful comments will help me refine the proposal-both to bolster the US's global competitiveness and to reduce the distortive effects of the tax code.

Robert Pozen (pictured above left) is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. He tweets @Pozen.

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