WaPo Doesn’t get the Tax Code
David Cho writes in the August 8th Washington Post that businesses are willing to incur enormous sums of debt because of incentives in the tax code, primarily the way businesses can deduct interest expense. Cho says:
Like other U.S. corporations, it also has had a uniquely American incentive for its borrowing habits: the nation’s tax laws. These rules offer extensive tax breaks to companies that borrow money and penalize those that raise cash in safer ways, such as issuing stock. Yet despite the recent financial crash, which exposed the perils of excessive borrowing, the rules are likely to persist in federal law because nearly all businesses in America would oppose eliminating these tax deductions, lawmakers say.
The article incorrectly discusses why businesses take on so much debt. J.D. Foster, Senior Fellow in the Economics of Fiscal Policy at The Heritage Foundation and former Associate Director for Economic Policy at the Office of Management and Budget explains why Cho’s assertions are wrong:
Calling the deduction of interest expense an incentive is wrong for two simple reasons relating to Income Tax 101. The first is that under an income tax, a business is allowed to deduct its expenses in calculating taxable income. Interest is a normal business expense. It should be deductible. There’s no incentive here.
Second, as our income tax is constructed, interest income should be taxable and interest expense should be deductible. This symmetry establishes neutrality. Take away the deduction for interest expense and you’ve not eliminated an incentive; you’ve created an artificial disincentive.
To be sure, there is a bias in the tax code in favor of debt, but it arises not from deducting interest but from overtaxing corporate equity, especially through the taxation of dividends and capital gains. Note that Obama has proposed raising the tax on dividends and capital gains, and Congress is readying a vastly greater increase in the taxation of dividends. So Obama’s proposals would exacerbate the bias in favor of debt. Curious these points were not mentioned in the Washington Post story.