Corporate Tax Reform

Editor’s Note: Robert Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. This post is based on a Tax Notes article written by Mr. Pozen and Lucas W. Goodman, titled “Capping the Deductibility of Corporate Interest Expense,” available here.

Amid the current debate over tax policy in Washington, there is a bipartisan consensus on one issue: the corporate tax rate, which is currently 35 percent, should be reduced to roughly 25 percent. At the same time, budgetary pressures preclude any significant increase in the deficit to accomplish corporate tax reform.

In light of these competing demands, most corporate tax reformers advocate broadening the corporate tax base to pay for any rate reduction. Unfortunately, few politicians have put forth base-broadening measures that would generate revenue sufficient to significantly lower the corporate tax rate on a revenue-neutral basis.

In fact, revenue-neutral corporate income tax reform is likely to be very difficult, because corporate tax expenditures represent a relatively small portion of total corporate tax revenues. A preliminary analysis by the Joint Committee on Taxation suggested that the elimination of all corporate tax expenditures—except for the deferral of tax on foreign source profits, a provision whose repeal would be politically and economically infeasible—would allow for the corporate tax rate to be reduced to only 28 percent.

Therefore, if policymakers want to reduce the corporate tax rate on a revenue-neutral basis, they will likely have to adopt other types of reforms to broaden the corporate tax base. Ideally, those reforms should offer the potential for significant revenue gains and reduce economic distortions.

In light of these criteria, we propose a revenue-neutral reduction in the corporate tax rate to 25 percent, financed by restrictions on the deductibility of gross corporate interest expense. In particular, our proposal allows nonfinancial companies to deduct only 65 percent of gross interest paid and allows financial companies to deduct 79 percent of gross interest paid (with special treatment for both financial and nonfinancial companies that would have otherwise realized a taxable loss). Based on historical data from 2000 to 2009, these restrictions would have raised approximately enough revenue to lower the corporate tax rate from 35 percent to 25 percent.

This proposal would reduce economic distortions because it would reduce the tax code’s significant bias in favor of debt-financed investment. Currently, corporate interest expense is (generally) fully deductible, while returns to equity (dividends or share appreciation) do not give rise to a deduction. A 2006 CBO model found that debt-financed investment faced an effective marginal tax rate (EMTR) of negative 6.4% in 2005, while equity-financed investment faced an EMTR of 36.1% (when financed by new shares) or 34.5% (when financed by retained earnings).

Using this same model, we find that our proposal narrows the gap considerably: Debt-financed investment would be taxed at an EMTR of 16.8%, while equity-financed investment would be taxed at an EMTR of 27.7% (new shares) or 25.9% (retained earnings). At the same time, the average EMTR for all corporate investment is roughly unchanged under our proposal (in fact, the model finds that this average decreases slightly).

Since the tax code’s bias toward debt does not appear to be justified by significant market failures, we believe the tax code should treat debt finance on a more equal footing than equity finance. Our proposal would encourage firms to make financing decisions based on underlying economic factors, rather than tax considerations. Critically, our proposal would also reduce distortions to investment decisions. Under the current tax code, corporations are incentivized to invest in projects that happen to be more suitable to debt finance, such as equipment that can be easily collateralized, rather than projects more suitable to equity finance, such as risky research and development projects.

In fact, there are significant negative externalities associated with excess debt—suggesting that the existing bias in favor of debt is especially damaging. All else equal, firms with excess debt (and thus higher required interest payments) are more likely to be forced into financial distress by a random shock. Financial distress generates harm to employees, customers, and suppliers—harm which is unlikely to be internalized by the firm. Excess debt may also exacerbate the business cycle by causing extended periods of deleveraging, which can harm third parties in the broader economy.

We recognize that our proposal would have a significant impact on the financial sector. Our proposal denies a deduction for 21 cents per dollar of financial sector gross interest expense (lower than the 35 cents applicable to the nonfinancial sector). This reduced rate balances two concerns. On the one hand, debt-finance is inherent to the operation of financial institutions—equity cannot easily replace the maturity transformation feature of debt. Thus, a large restriction on the deductibility of interest expense would disproportionately harm the financial sector.

On the other hand, externalities and other market failures of excess debt appear to be more severe within the financial sector, compared to the rest of the economy. For instance, the failure of a financial firm (an event made more likely by excess leverage) can trigger waves of panic, reducing the confidence on which other financial institutions rely.

Furthermore, the failing firm may need to quickly sell off assets in a “fire sale,” which could cause price reductions that reflect limited liquidity, rather than changing economic conditions. Other financial institutions would (in some circumstances) be required to use these “fire sale” prices to value their own assets—which could make an otherwise solvent financial institution appear insolvent, triggering further fire sales, and further price reductions.

We also recognize that these limits to the deductibility of interest would make it more expensive for banks to raise funds, potentially causing a reduction in lending to consumers and small businesses. While this outcome is clearly undesirable, we believe that the financial sector is currently overleveraged from the standpoint of society as a whole. In other words, we argue the adverse effects on bank lending are outweighed by the benefits of the proposal: a more competitive corporate tax rate, more efficient debt/equity decisions, and a less leveraged financial system — all of which can help drive long-run economic growth.

Given the wide-ranging consequences of our proposal, we do not suggest imposing it overnight. Ideally, the proposal would phase in linearly over ten years, meaning that the corporate tax rate would reduce by one percentage point each year and the deductibility of interest expense would be reduced by 3.5 (or 2.1) percentage points each year. Furthermore, regulators may need time to develop anti-abuse rules, especially regarding the distinction between “financial sector” interest expense and “nonfinancial sector” interest expense.

In short, we believe that much-needed reductions in the corporate tax rate should be financed by capping the deductibility of interest expense. Our proposal would roughly hold constant the average EMTR facing corporate investment, while reducing the tax code’s significant bias for debt, which distorts decision-making and makes the financial sector more fragile.

Of course, Congress need not finance the entire rate reduction with such interest caps. Congress could allow, for instance, 80 or 90 cents of every dollar of interest expense to be deducted. However, if Congress still wished to reduce the corporate tax rate to 25 percent on a revenue neutral basis, it would need to eliminate large corporate tax expenditures. While few base-broadening measures are politically popular, restrictions to the deductibility of interest expense could be more politically feasible than other options that raise substantial revenues.

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  1. […] Corporate Tax Reform Posted by Robert C. Pozen, Harvard Business School, on Thursday January 10, 2013 at 9:17 am […]

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