A good GOP move on tax reform
One of the biggest defects in the U.S. tax code is that it encourages companies to finance themselves by borrowing rather than by issuing equity. Correcting this bias should be a top priority for President Donald Trump and Republicans in Congress as they merge their plans for tax reform.
The tax preference for debt over equity is neither new nor confined to the U.S., but that doesn’t make it good policy. Many governments treat interest on debt as a deductible expense, so payments to creditors don’t get taxed while payments to shareholders do. This tilting of incentives has no good justification and can be dangerous.
Highly leveraged enterprises are much more likely to fail in an economic downturn. This fragility is what turns isolated asset bubbles into major catastrophes. It’s why the subprime boom of the 2000s, financed largely with credit, was so much more damaging than the equity-fueled dot-com craze of the 1990s.
Washington is working on a tax overhaul that affords a chance to put this right. Republican lawmakers have already proposed ending the deductibility of interest expense net of interest income. That’s a step in the right direction, but it isn’t ideal because it wouldn’t affect companies that have a lot of interest income — notably banks, where the problem of excessive leverage is especially serious. (The plan envisages separate rules for financial companies, but it’s unclear how these would work.)
A better approach would be to treat debt and equity the same for all companies, financial and non-financial alike. For example, economist Alan Auerbach of the University of California at Berkeley has suggested a system that would, in effect, tax a company’s returns after allowing for the cost of both debt and equity — rather than focusing, as now, only on the profits that accrue to shareholders. As well as removing the bias in favor of leverage, this would encourage investment in general.
A plan as far-reaching as that might be too ambitious, but legislators could get some of the benefits simply by allowing a deduction for the cost of equity capital to match the deduction on interest. Either way, Mr. Trump and his allies in Congress should make removing the bias in favor of debt a main goal of their reform.
The tax preference for debt over equity is neither new nor confined to the U.S., but that doesn’t make it good policy.