A Bold Idea (about Taxes)

When I first heard the idea of eliminating net interest expense deductions in the proposed GOP tax reform plan, I thought it was a terrible idea. But the more I think about it the more I like it, especially when it is combined with another GOP tax reform – the immediate deduction of capital investment.

Currently, if you borrow money to invest in a capital asset, you get to deduct the interest expense on the loan but you have spread the cost of the capital asset over many years through an annual depreciation of the original expense. If the asset depreciates over ten years then it will take ten years for you to fully deduct the cost of the investment. The government is front loading their collections of taxes and you have to wait to get the tax benefit of your investment. The current tax law also allows you to deduct your interest expense on any money you borrowed to make the investment but you are not able to deduct the expense of any dividends you pay to your equity investors (unless your company is an S corporation or a partnership). In my book, Principled Policy (2016), I had argued to make dividends tax deductible but the GOP proposal takes it the other way.

The current tax treatment punishes equity investment with higher costs and rewards borrowing with lower costs. This has resulted in higher amounts of leverage in our corporations. Higher leverage increases financial risk making them more vulnerable to business downturns and bankruptcies.

The non-deductibility of net interest expense will increase the cost of doing business but not as much as I had originally thought. Unless you are in a very highly leveraged company or in a very low margin business, the elimination of net interest expense deduction will have only a small impact on your earnings. If you are so highly leveraged that the lack of interest deductibility severely impacts your earnings then you are investing in assets with low margins that cannot support so much debt. Implementing this tax reform will discourage excess leverage and make the country less susceptible to recessions.

By allowing the immediate deduction of capital investments, the government is back loading the collection of taxes and giving you the upfront benefit of your investment. Depending on the type of industry a company is in, a large capital investment could substantially reduce taxes owed (which is why the government prefers extended depreciation). Fast growing companies might not pay any taxes at all for many years. Democrats and progressives might think this is horrible but, if you think about it, more investment contributes to GDP and employment so this reform would accelerate growth and provide jobs.

Coming from the financial industry, I was concerned about how these reforms would impact banks and other financial companies. But financial companies usually have net interest income instead of a net interest loss. Net interest income is used to pay for most of all the other expenses of running a financial company. Financial companies usually fail because of asset/liability mismanagement, excessive leverage or illiquidity (usually in combination) and not so much due to losses from negative spreads. If a financial company had a negative interest spread it would likely have no income and therefor would pay no income tax anyway. The lack of interest deductibility would only affect their tax loss carry forward if and when they return to profitability.

The elimination of net interest expense deduction would also square corporate taxation with the taxation of individuals (except in the case of the mortgage interest deduction which I have also advocated to be eliminated). Technically, for philosophical precision, individuals should be able offset their interest income with their income expenses but, since most individuals except the very rich have much more interest expense than income I doubt our tax hawks in DC would allow that.

So the elimination of net interest expense as a deduction and allowing immediate deduction of capital investments from corporate taxes would increase the cost of debt, reduce the incentive to increase leverage, promote investment and reduce the chance of recession. I think that’s a good thing. The major risk to this reform, and it is indeed a major reform, will be efforts by industry associations and special interests to carve out exceptions and special treatment to this overall policy shift. Congress would then be pushed to reduce the effectiveness of this reform by allowing all sorts of special treatment to specific individuals and companies. This is precisely the problem with the current tax system and why it is so badly in need of reform. It would be a shame if a bold idea such as this would be reduced to a 5,000-page modification to the tax code that only impacts those that lack clout in Washington.