Monday, November 16, 2009

Deducting interest

Felix Salmon argues here and here for not allowing corporations to deduct interest paid as an expense when calculating their income for tax purposes. Matthew Yglesias offers support here .

Salmon is usually interesting but sometimes he runs completely off the rails as here. The idea of the corporate income tax is to tax profits. It is completely clear that interest paid is an expense not profit. There is no loophole as interest received is income.

There is currently an issue in that dividends are double taxed, they are not deductible to the payer but are taxable to the recipient. This does encourage debt financing as compared to equity financing. This could be changed by making dividends paid deductible or dividends received tax free (currently dividends received are taxed at a preferential rate which is roughly equivalent to only taxing half of them). Double taxing interest as well is a fix which is far worse than the disease. It would be difficult to implement as lots of transactions incorporate an interest component implicitly. And it would cause severe dislocations in existing arrangements for no good reason.

There are numerous ways of discouraging excessive leverage that do not involve completely fouling up the existing system of income taxation.

As for Yglesias he claims:

Our political culture is highly biased in favor of tax cuts, which leads to a lot of subsidies being doled out that nobody would take seriously. If I said “every time a business makes $1 in interest payments, we should give them a quarter and pay for it with higher overall corporate tax rates” nobody would think that made sense. ...

Thus demonstrating his ignorance as this in fact makes excellent sense to anyone familiar with the principles of the corporate income tax.

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