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
With that said, let me address the main objections to my proposal.
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
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.
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.
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
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
Observers frequently argue that my
interest cap should apply solely to net interest expense,
rather than gross interest expense. I disagree for two
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
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
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.
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.
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
Robert Pozen (pictured
above left) is a senior lecturer at Harvard Business School and
a senior fellow at the Brookings Institution. He tweets