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Bush and Rubio Pave the Way on Corporate Tax Reform

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Bush and Rubio Pave the Way on Corporate Tax Reform

September 17, 2015

It did not come up much at last night’s debate, but there is a lot to like in the tax reform plans of Jeb Bush and Marco Rubio. They slash America’s corporate tax rate from the highest in the world to somewhere in the middle of the pack. They expand the Earned Income Tax Credit, a proven poverty-fighter, and lower individual rates to give working families a bigger paycheck. They may or may not bring the economy to four percent growth, but they are a good start.

Bush would eliminate the tax deductibility of corporate borrowing costs. This provision has sparked some controversy, even among pro-tax reform commentators. However, it would equalize the treatment of debt and equity, the two channels through which corporations can finance new investment, so it is a positive development. 

Eliminating the corporate tax deductibility of interest is also a major component of the tax reform proposal of Senators Marco Rubio (R-FL) and Mike Lee (R-UT). Like Bush, Rubio and Lee would no longer allow businesses to deduct new debt, but would also remove the individual-level taxation of interest and capital gains entirely. As in Bush’s plan, this would create a balance between debt and equity, but boost the after-tax share of these financial instruments more substantially.

Why does this provision matter? Theoretically, it should not make a difference to firms which option—debt or equity—they choose. The catch is that, under the current system, they can deduct interest payments on the debt from their taxes, while they still must pay taxes on any profits they return to equity owners.

Bush and many economists see this tax preference as distortionary. It favors debt over equity, leading many firms to load up unnecessarily on debt. Such a practice, called leveraging, is dangerous: if a firm borrows too much it may not have a sufficient “cushion” of equity to absorb losses during hard times. Excessive debt led Lehman Brothers and other companies to collapse during the 2008 financial crisis. 

The tax preference for debt does have an effect on leverage. In a 2014 paper, UCLA professor Francis Longstaff and Stanford professor Ilya Strebulaev found that a 1 percent increase in the corporate tax rate boosts leverage by 0.18 percent. Higher corporate taxes make the debt preference more pronounced, so the paper’s findings are evidence that the debt preference does influence leverage.

Supporters of scrapping the tax deductibility of debt argue that if equity is taxed at both the corporate and individual level, debt ought to be as well. Opponents counter that such a move would increase the cost of borrowing for firms and thus hurt the economy more than help it. Both sides have a point, but it turns out that the viability of each argument depends a lot on the numbers.

How, exactly, would corporate tax liabilities change under the Bush tax plan? Currently, equity owners face a 35 percent corporate tax rate and a 23.8 percent top capital gains tax rate. For every $100 in corporate profits returned to equity owners, they pocket $49.53.

The treatment of debt is different: the only tax debtholders face is a 39.6 percent top tax rate on income. For every $100 in corporate profits returned to debtholders, they pocket $60.40. The preference for debt is obvious—corporations can return 22 percent more in after-tax profits to debtholders than to equity owners.

 

 

Under the Bush tax plan, rates would get cut across the board. The corporate tax rate would fall to 20 percent. Capital-gains tax rates would go down to 20 percent as well, and interest on debt would be taxed at capital-gains rates.

This would drastically change the returns investors see after taxes. Equity owners and debtholders alike would get $64 for every $100 returned to them in profits. Under Bush’s system, the tax preference for debt over equity would get wiped out.

Equity’s after-tax share of corporate profits would rise by nearly 30 percent, while debt’s share would increase by a little under 6 percent. Bush’s tax plan, therefore, would amount to a big tax cut for equity owners and a small tax cut for debtholders.

Under Rubio’s proposed corporate rate of 25 percent, debtholders and equity owners would each get to take home $75 per $100 returned to them in profits. The plan would not tax capital gains or interest income. This would eliminate the preferential treatment of debt while also not raising the cost of borrowing, and cuts the tax wedge further on corporate profits than does the Bush proposal.

All these calculations, of course, ignore state and local taxes and assume most investors are in the top tax bracket. That does not tell the whole story. Some investors, such as college endowments, do not pay taxes on capital gains or debt interest. Eliminating the tax advantage of debt would hit them much harder than ordinary investors, since their gains would now be filtered through a corporate tax. However, they would see no reduction in individual taxes to compensate (since they don’t pay any).

Under Bush’s plan, non-taxpaying investors would see a 20 percent reduction in their after-tax share of profits. Under the Rubio-Lee plan, this reduction would be 25 percent. Reductions in after-tax share cause debtholders to demand higher interest rates, increasing the cost of borrowing for firms. Whether this effect would outweigh the small tax cut given to ordinary, taxpaying debtholders is unclear.

Supporters and opponents of eliminating the tax deductibility of debt both have a point. The Bush and Rubio plans would equalize the treatment of debt and equity under the tax code. On paper, it could reduce the cost of borrowing for firms by giving ordinary investors a small boost in after-tax share, but this effect could be reduced (or even outweighed) by the new burden on non-taxpaying debtholders.

Equalizing the tax treatment of debt and equity is an important policy priority. Both Bush’s plan and the Rubio-Lee plan accomplish this goal on the federal level, which would reduce corporate borrowing without a sufficient equity cushion.

If there’s an area for improvement, though, candidates who propose ending the tax deductibility of debt should also look into lowering the corporate rate even further, which would soften the blow on non-taxpaying investors. In addition, it would make the American tax environment more globally competitive. But there’s plenty of time to tinker with the numbers.

 

Preston Cooper is a Policy Analyst at Economics21. You can follow him on Twitter here.

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