Tax debt and equity the same way

In the US, for tax purposes interest on debt is treated as a business expense. It is, in other words, tax deductible. But it is not in fact a business expense at all. It is a form of return on capital, like dividends paid out to company owners. Treating interest as something it is not gives companies an incentive to finance themselves with debt rather than equity. This is dangerous, because high debt makes financial systems fragile.

Unlike equity, the value of debt does not decline when economic conditions deteriorate. Unlike dividends, interest payment cannot be halted without triggering a default. So debt poses a particular threat to weaker companies’ survival when times get hard and exaggerates the business cycle.

It is welcome news then that a Republican tax plan proposes to cap the interest deduction. The ceiling for net interest expense would be set at 30% of a company’s taxable earnings — understood as earnings before interest, taxes, depreciation and amortisation (ebitda). That it is “net” interest that is capped is important, as it in effect excludes banks, whose leverage is already regulated.

The proposal is timely, too. According to data from the Federal Reserve, total nonfinancial corporate debt stood at $8.7-trillion in the first quarter of 2017. As a proportion of GDP that is a high of more than 45%, barely edging past the previous highs of late 2001 and early 2009 — both of which occurred when cyclical peaks were turning over, not as the economy was accelerating.

Critics of the law will point out that nonfinancial corporate debt was not the direct cause of the past two financial crises. This is true as far as it goes, but high corporate debt seems likely to have increased the volatility of stock and debt prices after the technology and housing bubbles burst.

Further, long experience teaches that it is hard to predict where in the wall of debt the cracks will first show. Best to limit debt across the system. London, November 7.