Why Slashing Interest Deduction Could Cause Trouble for Businesses

Why Slashing Interest Deduction Could Cause Trouble for Businesses

Healthcare reform has taken center stage once again, but tax reform still lurks in the background. It’s yet another issue that Congressional Republicans cannot agree on, mainly on the border adjustment tax.

But there’s a tax deduction the Republicans may eliminate that could cause problems and possible resistance among lawmakers, including within the party: interest deduction.

The Wall Street Journal has pointed out that taking away “the deduction that companies get for interest they pay on debt” affects everyone from those on Wall Street “to wheat farmers in the Midwest looking to make ends meet before harvest.”

How This Tax Deduction Works

This deduction has caused our financial system to become “heavily oriented toward debt, which because of the tax code is often cheaper than equity financing – such as sales of stock.”

Furthermore, eliminating this deduction could alter our entire system. WSJ explains:

Getting rid of the deduction for net interest expense, as House Republicans propose, would alter finance. It also would generate about $1.5 trillion in revenue for the government over a decade, according to the Tax Foundation, a conservative-leaning think thank.

The plan would raise money to help offset Republicans’ corporate tax cuts and reduce a “huge bias” toward debt financing, said Robert Pozen, a senior lecturer at MIT’s Sloan School of Management. That bias, he said, hurts companies built around innovation, which tend to not have the physical assets that banks usually require as collateral.

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In a world with no interest deduction, debt-fueled leveraged buyouts by private-equity titans could become more expensive to finance and junk bonds less appealing. “That’s not necessarily bad for society,” said David Beim, a retired Columbia University finance professor. “We have too much systemic financial risk in our economy.”

Our tax code is a tad more lenient on debt than equity financing. A company’s “profits can thus be subject to two layers of tax – once at the business level and then when they go to shareholders in the form of dividends.” From WSJ:

That means the effective marginal tax rate on equity-financed corporate investments is 34.5%, according to a report released by the Treasury Department this year in the waning days of the Obama administration. The corresponding rate for debt-financed investment is negative 5%. That subsidy for corporate debt “potentially creates a large tax-induced distortion in business decision making,” the report says.

But borrowing and deducting interest are deeply ingrained in American corporate finance as a normal cost of doing business. Dislodging the traditional practice will be challenging. Some firms might look to borrow offshore instead to reap tax benefits elsewhere.

“I don’t even think people think about it much,” said MIT’s Mr. Pozen. “It’s clear that they’re going to finance it by debt if they have a big acquisition or a big project.”

How Elimination Will Affect Business Owners

Earlier this month, 30 agriculture groups asked the Republicans to keep the interest deduction when they work on tax reform. From The Hill:

The agriculture groups said in their letter that most family-owned farms rely heavily on credit, and that agricultural producers use debt financing to purchase land and equipment.

“Eliminating the interest deduction will place further financial stress on an already debt-burdened industry, and prevent producers from staying profitable in challenging economic times,” they said.

The groups also said that debt financing will be particularly important for those seeking to get into the agriculture industry.

“As older producers exit the workforce, financing will be critically important for new and beginning farmers and ranchers looking to establish businesses,” they said. “Eliminating interest deductions creates a significant barrier for the next generation.”

WSJ spoke to farmer Andy Hill, who makes a living growing corn and soybeans in Iowa. He told the publication that “he pays less than $10,000 a year in interest on a line of credit between $100,000 and $200,000.” WSJ continued:

That loan helps him bridge gaps between his expenses and his income, between when he needs to buy seed and fertilizer and when he sells his crops.

“[Losing the ability to deduct interest] wouldn’t put me in the red by any stretch of the imagination, but it makes it very debilitating as far as household income,” said Mr. Hill, who added that he has reached out to both of his senators and his House member about the issue.

Robert Moskovitz at Leaf Commercial Capital explained that people utilize that debt “because they don’t have the cash and they don’t have access to equity.”

Why Does the GOP Want This?

Congressional Republicans want people to have the ability “to write off the full costs of their investments.” The leaders have stated they believe that this approach “would provide more of an incentive for business to invest.” From Bloomberg:

Asked about the White House’s support for keeping interest deductibility, a spokeswoman for Republicans on the House Ways and Means Committee touted the benefits of immediate expensing. The panel’s GOP members “have proposed full and immediate expensing for all businesses because it will deliver robust economic growth and create jobs,” said spokeswoman Emily Schillinger, who added that it’s just one component of the proposed tax overhaul.

House Ways and Means Committee Chairman Kevin Brady (R-TX) has said that he could change his mind and keep the interest deduction for small businesses since these owners “often don’t have access to capital markets.”

Treasury Secretary Steven Mnuchin wants to keep this tax deduction, and Senate Finance Committee Chairman Orrin Hatch (R-UT) admitted it will not be easy to take away.

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