Scott Sumner  

Why are interest expenses tax deductible?

PRINT
Do We Just Owe it to Ourselves... The Psychology of Trolling...

It's pretty clear to me why mortgage interest is tax deductible--homeowners (and builders, realtors, bankers, etc.) are a very powerful special interest group. This post asks a different question. Why is business interest deductible against taxes on business earnings? Perhaps that also has a simple answer, but that's less clear to me.

Most countries have tax systems that favor debt financing over equity financing. The cost of equity (dividends, etc.) is not tax deductible, while interest is deductible. But why? More specifically, why not eliminate the deductibility of interest, and at the same time lower business tax rates enough so that the change is revenue neutral? That would seem likely to improve economic efficiency, and also lower debt as a share of GDP. It's not obvious to me why this change would be bad.

And it's also not obvious why it would be politically unpopular. Some businesses would gain and some would lose, but in net terms there should be a gain from the greater efficiency associated with lower MTRs on business income. Is the answer that the political muscle of the businesses that would lose is greater than the influence of the larger group that would gain? My impression is that in the US neither political party favors this sort of revenue neutral tax reform. Is that correct? Are there any countries that tax debt and equity equally?

PS. You could make the cost of equity tax deductible, but unless I'm mistaken you would no longer collect any revenue from taxes on capital income.


Comments and Sharing






COMMENTS (43 to date)
Pemakin writes:

This issue is complicated by lease and rents (effectively debt but not under the tax code). Seems to me businesses would find a way to try to turn everything into an operating expense and try not to own any capital assets.

Perhaps this suggests that no income tax is really efficient. Only consumption taxes work.

Chuck writes:

Just make dividends deductible.

RobertB writes:

Wouldn't this create a whole new swathe of double taxation? It may not make much different to C corporations, whose net income is already subject to two layers of tax, but for John Q. Sole Proprietor, using debt in his business becomes much less attractive, because the government is effectively getting two bites at the income stream that is financed with debt: once when John receives the income and a second time when his creditor gets interest payments.

There is a reasonable case for making business interest payable by C corporations nondeductible, but you would probably need to make C corporation interest received by other C corporations excludable from income or you would run the risk of stacking up huge tax burdens on leveraged lending businesses.

Isegoria writes:

Many businesses transactions include an implicit loan with hard-to-define interest, such as materials bought net-30.

moritz writes:

It is maybe related to the question of cashflow within the current period. Suppose a firm has an EBIT of 100 and interest payments of a 100 (real cash is going out to the lenders) so that the effective tax burden is 0, if the interest expense is deductible. If it were not deductible it has to come up with e.g. 30 just to pay the taxes for the period, but the cash to do so wouldn't be there any more..

Lawrence D'Anna writes:

I think I can say why its politically unpopular.

Your proposal is to lower taxes on "corporate profits" by raising taxes on something voters don't understand. All they'll hear is you want to lower taxes on "corporate profits".

Maybe if you could phrase it as lowering taxes on their 401k they'd go for it.

The tax treatment mirrors the financial statement treatment. We deduct interest expense on the financial statements, but we don't deduct the cost of equity as an expense. There are obviously differences between tax accounting and "book" accounting, but for the most part they follow the same principles. There are also notable departures between accounting income and economic income, but these are mostly for practical reasons. How would you have companies calculate the cost of equity? (and I don't mean just dividends of course)

Personally, I don't have a problem with interest being a deductible business expense. It's a perfectly legitimate business expense. We don't ask why other legitimate business expenses such as depreciation expense aren't deductible.

However, I do feel that dividends should be a deductible expense as long as they are taxable as personal income.

Anon writes:

Mark - just a wild guess here but assuming if interest was no longer tax deductible we would no longer deduct it on the financial statements.

Levi Russell writes:

Interest is deductible because it is a cash expense like the rest of the expenses on the income statement. Yes, I do think it's that simple.

Mercer writes:

"Perhaps that also has a simple answer,"

The answer is the interest deduction was created for business and farm income not for homeowners.

In 1913 most individuals did not pay income taxes or pay a residential mortgage. Decades later when they started to pay taxes and mortgages they used the interest deduction put in place for businesses.

Matthew O'Donnell writes:

In general, instituting more double taxation in the system would seem to be robbing Peter to pay Paul.

On efficiency grounds I suggest the Australian system where tax paid on equity distributions are effectively made tax deductible is a better solution.

Company tax paid is netted against income tax owed so the total tax paid on distributions is equal the individuals income tax rate.

Why have a company tax under this scenario?

1) To discourage companies from retaining earnings to delay tax payments by individuals.

2) Tax overseas investors. Because of politics etc very difficult for overseas investors to get tax deductions from their domestic tax collector for taxes paid overseas. In essence a semi free kick (mind you there would be second order effects which reduce the benefit eg changes in exchange rates, distortion of investor base)

bill writes:

For partnerships, interest is a deductible expense to the partnership and taxable income to the lender. The residual income on the equity isn't taxed at the partnership level but becomes income to the partners.

Eric Rall writes:

"PS. You could make the cost of equity tax deductible, but unless I'm mistaken you would no longer collect any revenue from taxes on capital income."

You could get part-way there by making dividend payments tax deductible to the payer and taxing the dividend as ordinary income to the recipient. Equalizing the tax treatment of retained earnings would be a bit trickier.

Scott Sumner writes:

Some of the comments point to the inefficiency of capital income taxation in general. Once you start down that road . . .

A lot of commenters seemed to focus on my "PS", which was considered and rejected. It seems pointless to allow the cost of equity to be deducted---why even tax capital in that case?

As for the other comments, I'm starting to think that perhaps more people are confused on this issue than I had assumed. Is it possible that Congress just made a mistake, and thought it was logical to treat debt more leniently than equity?

David N writes:

Doesn't economics teach us that it doesn't matter which side of a transaction is taxed? Interest is taxable income to the creditor. If you tax the debtor as well you're just double-taxing. Should a business have to pay taxes on a loss if interest expense is greater than the net loss?

As far as Congress making a mistake, maybe they made a mistake in 1986 when they made personal interest non-deductible. Originally, all forms of interest were deductible.

The way to put equity and debt on an equal footing is to let corporations issue dividends pre-tax.

Josh writes:

[Comment removed for supplying false email address. Email the webmaster@econlib.org to request restoring your comment privileges. We'd be happy to publish your comment. A valid email address is nevertheless required to post comments on EconLog and EconTalk.--Econlib Ed.]

Phil writes:

If interest wasn't deductible, you'd have double taxation.

Bob sees a 10% business opportunity. He invests $1000, earns $100, and pays tax on $100.

Bob sees a 10% business opportunity. He doesn't have $1000, so he borrows from Mary at 5%. The business earns $100 before interest. Bob pays Mary $50.

If Bob paid tax on $100, and Mary paid tax on $50, you'd be taxing the overall business on $150, when only $100 in value was created.

Nathan writes:

I'm not very knowledgeable about the system, but Australia's franking of dividends might be an example of what you're looking for.

Andreas Shepard writes:

There's two different ways of thinking about this issue that I think lead people to different intuitions. Call one the Sole Proprietor Mindset and one the Corporation Mindset.

In the Sole Proprietor Mindset, you think from the perspective of someone who owns the business. As the owner, you need to obtain resources to operate the business, and the costs of doing so are expenses which reduces your profits. When you hire workers, your wages are an expense. When you buy raw materials, the cost of those is an expense. And when you take a loan from the bank to buy equipment, your interest cost is an expense. From this perspective, it seems obvious that interest should be taxable. It reduces your take home profit (as the equity owner) like any other expense, and it's only fair that you only pay taxes on the profits you make.

In the Corporation Mindset, you take the perspective of the business as an independent entity. As a business, you need capital to operate, which you can raise either via debt or equity. In exchange, you provide some sort of compensation to the capital provider. For debt, you pay interest. For equity, you pay dividends. From this perspective, it seems obviously silly that interest is tax deductible but dividends are not. After all, both are just payments to someone who provided you capital. Their tax treatment should be the same.

I see the intuitive appeal of both of these mindsets, which makes it annoying that they lead to opposite intuitions. However, I think the Corporation Mindset is the correct one.

The Sole Proprietor Mindset ignores the fact that, when you take on debt you are effectively giving up some ownership in the company. The debtholders don't have voting rights, but if you go bankrupt they take over your assets and become the new equity owners.

Therefore, the interest you pay isn't really an expense - it's the portion of the profits paid to other owners (just structured so they get a defined payment rather than a percentage). It reduces your personal take home profits, but that's just because you are splitting the value of the business with another owner. If you were to bring on a business partner and give her a 20% stake, your take home profits would decline by 20%. But that doesn't mean you get to deduct those profits as an expense!

Of course, this just implies that interest and dividend payments should get the same tax treatment, but not what that tax treatment should be. There are several consistent options that also avoid the double taxation problem:
a) no corporate tax at all. debt and equity holders pay taxes on the full interest/dividend income
b) corporate tax, with interest and dividends both tax deductible. debt and equity holders pay tax on the full interest/dividend income.
c) corporate tax, with interest and dividends not tax deductible. debt and equity holders pay tax on only a portion of the interest/dividend income, such that the total tax is the same as in option b (this is something called corporate integration, and is what Australia and Estonia do. see: http://taxfoundation.org/article/eliminating-double-taxation-through-corporate-integration)

Personally, I prefer option C, but there are arguments for the others as well. Which one is best will depend on how the rest of tax code is structured (e.g. personal income tax rates on dividends vs. capital gains vs. interest)

acarraro writes:

If interest is non-deductible, why would rents be deductible? They are the same arrangement. Are you really arguing that a business should be required to own outright any resource/asset it uses (land/buildings/money/machinery)? This sounds very stifling to me. It raises the bar to starting new business very high I think.

I think the idea that a corporation "pays" dividends is simply wrong. The owners and the corporation are the same thing. It should make no difference to owners if they receive dividends or not. This is as wrong as the idea that interest pays no tax, they are just paid but the person receiving the interest.

I don't really believe debt financing is very inefficient to be honest... It helps create leverage which is helpful in terms of incrementing investment. I think the equal distribution of losses in case of failure would stifle investment as it would reduce risk capacity in general.

pascal writes:

In Belgium, we "invented" the so called "notional interest" which make a fictional interest on the equity being deductible from the businnes income.

this interest is set to be the the one on the 10 year OLO bonds borrowed by Belgium.

so with an equity of 100, an notional interest of 3,5% and businness earning of 10, the income tax would apply on 6,5.

the small business mainly refused this as a replacement of prior measures

notional interest was mostly used by multinational to optimise financial flow by making a belgian subsidiary lend to their other subsidiaries, therefore allowing double de-taxation (interest on one side, notional interest on the other), those companies where typically a handfull of employee plus a handfull of billions to lend.

Thomas B writes:

I've wondered about this for years (and yes, I've got a pretty deep knowledge of finance). It seems illogical to me: if anything, the tax code would make more sense if it made returns to equity tax-deductible, but not interest on debt. Why? Because the tax code, being the way it is, is an incentive for businesses to use leverage and thus financially destabilize themselves. When we have recessions, all that debt financing is why businesses wind up in bankruptcy, instead of muddling through.

The idea that "interest is a legitimate business expense" is a strange one, in a world where we believe that returns to equity investors are not a legitimate business expense. That's because the loan is just a form of financing, and can be thought of as a separate arrangement between the lenders and the equity owners, having essentially nothing to do with the operations of the business itself. The loan is simply a step where the equity owners borrow money for their own use, secured by their claim on the business.

A thought experiment may help.

Imagine a business that is entirely equity financed. The owner now decides to buy a car, and as collateral for the loan puts up her ownership stake in the business. She gets the loan, buys the car, and pays interest on the loan. This is not a business expense: it is consumption by the owner. The interest is a cost to the owner, not the business.

Now, suppose instead she has the business take out the loan and buy shares from her with the money (at par - no capital gains here). She still owns the business, she has the cash, she buys the car. Why, suddenly, is the interest on the loan for her car a "legitimate business expense"? In economics (and finance) when two situations produce the same cash flows, they should be viewed as the same situation. The interest on the debt in this second case is is no more (or less) a "legitimate business expense" than in the first situation. It is a car loan for the owner.

I understand that the business may "borrow money to buy new computers", but this is just smoke and mirrors. Let's buy those computers but add a few steps: a) the owner adds new capital (her own business creates shares and sells them to her), and the business buys the computers with the money - but as a result the owner cannot buy the car she wants b) the business borrows money c) the business buys back the new stock from the owner with the borrowed money d) the owner buys the car. End result is the same: there is a loan; the business has the computers; the owner has the car. It's a car loan disguised as a computer purchase.

Borrowing is the same as not using equity, and as such the loan simply enables the equity holders to do something else with their money. Thus, in reality, it is the equity owners who are borrowing. If the return to equity is a legitimate business expense, then when the business reduces total equity by borrowing, the interest on the loan is legitimate; but if the return to equity is not a legitimate expense, then neither should be the interest on a loan that displaces equity.

I assume that, having arrived at the - frankly pretty foolish - arrangement actually in our tax code, we are now trapped by path dependence. Whoever would lose from a change will shout louder than those who would gain - especially because the latter may not know who they are at first, never having spent any time thinking about it.

Njnnja writes:

You have to put aside that we now know Modigliani-Miller.

If you were trying to create accrual accounting from scratch, you would start with revenue and subtract out all of your business expenses to get Net Income. It is reasonable for a taxing authority to apply whatever corporate tax on that Net Income (although note that in the US the accounting and taxation books have diverged).

So the question of why is interest tax deductible and dividends not is really rooted in the question of why do interest payments pass through the income statement but dividends go directly to the balance sheet.

It makes sense that pre-Modigliani-Miller people would include interest *expense* as an expense. But then the question is "Why wouldn't they include dividends as an expense? It's clearly going to go through cash flow." The answer is that a big equity raise shouldn't increase income in the period the equity is collected, so a return of equity (in the form of a dividend) shouldn't decrease income in the period the equity is returned. Otherwise, you could show legitimately huge profits just by running a Ponzi scheme that keeps attracting new capital. So cash flows to and from equity holders are *not* expenses or income.

Jeff writes:

There is an obvious way to fix all of this: Repeal the corporate income tax altogether but tax all income to people at the same rate. That means capital gains, dividend income, income from wages, interest income, all of it. Treat all income, from any source, the same. You could still have 401K-type accounts if you want to only tax consumption, but withdrawals from those accounts would be taxable at the same rates.

Just think about all those corporate tax lawyers and accountants, many of them very smart, putting their intelligence to work on something useful, rather than tax avoidance. Also, think of how the double taxation of corporate income under current law favors debt over equity financing. More equity and less debt would probably improve both financial and macroeconomic stability.

R Richard Schweitzer writes:

Interest, charge for use, is a transactional event.

Currently it ** IS ** taxed as income to the recipient.

William Bruntrager writes:

Great answer by Phil. Interest expenses are tax deductible because they should be; it just makes sense. It seems odd to search so diligently for an explanation of why something is exactly as it should be. Better to look at a case where there is a discrepancy between what is and what ought to be, and try to explain that.

Scott Sumner writes:

David, You said:

"The way to put equity and debt on an equal footing is to let corporations issue dividends pre-tax."

I think you'd either have to end all taxes on capital income, or stop allowing interest to be deducible.

Phil, But why treat equity differently from debt?

And if interest was neither taxable nor deductible, then would anything change?

Andreas, The best option is to not tax capital income at all, but otherwise your comments are mostly correct.

acarraro, Your comment doesn't address the question. Why should we tax debt financed capital more lightly than equity financed capital.

Pascal, I suppose that would be slightly better.

Thomas, Very good analysis.

Njnnja, I think you are showing the absurdity of trying to tax capital at all.

Jeff, Excellent. As long as you have the 401k option I'm fine with that.

Njnnja writes:

@Thomas B

The two scenarios that you present are not exactly equivalent and therefore would not be expected to have the same treatment. If she fails to make interest payments in the first case, the lender has recourse to the shares of equity put up as collateral - they will become equity holders in the company. But in the second case, if the company doesn't make payments, the lender has recourse as a general creditor to the assets of the company (or to some specific collateral such as the purchased computers). But the difference between owning the assets of a company versus merely owning the stock of a company is the difference between sole proprietorship and embezzling.

However I think your point about path dependency and now we are stuck with the system we have is spot on.

Jim Glass writes:

Why is business interest deductible against taxes on business earnings? Perhaps that also has a simple answer, but that's less clear to me.

It's not deductible "against taxes" on business earnings. It is deductible against income in determining net income. (A very non-trivial difference.)

And yes, the reason is very simple:

An income tax system requires computation of net income as the amount to be taxed. Thus the general principle is that when a form of income is taxable, expenses incurred to earn that income are subtracted from, deducted against, that income to determine its net amount.

This is true for individuals as well as businesses.

Business income is taxable. Business expenses incurred to produce business income are deducted against it in determining its net amount. Simple enough.

Interest received is income to a business, added to its taxable income, and interest paid as an expense of earning such business income is deductible against it in computing its net amount. Just part of the above.

It's the same for individuals: individuals' interest received is taxable investment income, and interest paid as an expense of earning taxable investment income is deductible against investment income ... gambling winnings are taxable income, and gambling losses and expenses are deductible against them (so keep your losing lottery and raffle tickets) ... employees' salaries are taxable income and employees' business expenses are deductible against it, etc. (given the ability in all cases to jump over and through specified, often quite challenging, hurdles and hoops). There are Tax Court cases that say even expenses of criminal activity can be deducted when computing net illegal taxable income.

OTOH, interest paid by individuals to finance personal and living expenses (*not* to generate taxable income) generally is not deductible. Exceptions such as the home mortgage deduction are just interest-group politics. Personal credit card interest and the like was deductible once-upon-a-time, but no more.

Similarly, interest paid by a business is *not* deductible if not incurred with the purpose of generating taxable business income.

Typically this occurs now only with private businesses that incur such interest in financing personal expenses for their owners (in which case the expense is likely to be deemed a taxable dividend to the owner) or while engaging in purely tax-driven tax shelter transactions.

But in the good old days of the 50+% tax bracket rate for corporations compounded by 70%-90% top tax bracket rates for their shareholders, these non-economic tax shelters with their mountains of manipulated interest expense were a huge issue even with public corporations.

In short, it's not that interest is taxable but that income is taxable, including interest -- and that the expenses of producing taxable income are deductible against it when computing its net amount, including interest when it is such an expense, but not when it is not.

(Of course the whole system is a function of politics, so politically driven exceptions can be pointed out in all directions, but that's another story.)


Scott Sumner writes:

Jim, You completely missed the point. Why is the tax treatment of debt and equity financed investment different? The cost of debt (interest) is deductible, but not the cost of equity. Why?

JohnF writes:

Jim Glass has it down right.

Dividends are also a voluntary act: those owning the company or those charged with running the company for the owners make that decision on a voluntary basis. Profits never need to be taken as a dividend, as any profits can be simply kept on balance and add then to equity on the balance sheet.

Interest paid on loans is the cost of that money (duh) and as such is part of operating expenses. Just like COGS (cost of goods and services) and personnel expenses, paying interest on debt financing is part of expenses. Disallowing the deduction of interest payments would be no different than disallowing the deduction of personnel costs or COGS from sales to determine the value added in production, which is (as profits) what is taxed at the end of the day.

ThomasH writes:

Deducting interest as an expense of earning income for businesses makes sense. Owners would prefer to pay low prices for borrowed capital in the same way as they they'd prefer that the price of any of the other things they purchase were lower. The anomaly about deducting mortgage interest on housing is that the implied income from the asset is not taxed.

Jim Glass writes:

Jim, You completely missed the point.

Did I? The questions were "Why are interest expenses tax deductible?", and "Why is business interest deductible...?"

The answer is that in an income tax system, as a matter of principle, when interest is an expense of producing taxable income it is subtracted from same in order to accurately compute net taxable income.

This is true for individuals as well as C corps that face corporate-level taxation (in fact the great majority of businesses nowadays are pass-through entities that don't incur corporate level tax, their income is taxed on their owners' personal returns, so individual rules apply.)

E.g., individuals can deduct interest incurred to receive taxable investment income from stocks and taxable bonds, but cannot deduct interest incurred to receive tax-free interest from tax-exempt bonds.

That's the answer to those questions. It's not an endorsement of the system - it's how the system works.

Why is the tax treatment of debt and equity financed investment different? The cost of debt (interest) is deductible, but not the cost of equity. Why?

OK, these are different questions. Let's step through things to make the issues clear.

Businesses A and B each purchase $100k of business equipment, the only difference being that A uses $100k of borrowing incurring 5% interest while B uses $100k of retained earnings out of the savings account, equity.

Their tax deductions (and whatever other tax benefits) for their $100k purchases are identical, there is no difference between them whatsoever.

A also thereafter incurs a $5,000 cash charge per year, which reduces its net cash flow and thus its annual income by $5,000. To recognize this, this cash flow expense is deducted against its cash flow income, so A is taxed only on its real net income. Seems fair enough on its face.

B, otoh, incurs no such expenses against income, so in an income tax system what deduction (beyond those it gets for buying the equipment) is it supposed to be entitled to claim against income, simply because it financed the purchase with savings? If the equipment is worth the $100k the company paid for it, then the company's equity value will be unchanged - $100k of value in cash simply converted to $100k in equipment assets. What's the "equity cost" of that? How do we compute the portion of its equity that is supposed to be deductible? What is the deductible expense against income supposed to be?

Businesses aren't seen to "incur equity as a cost of producing income" -- that's why use of equity isn't deductible against income as a business expense.

Again, this isn't a defense of the system but only an answer to the question. The deductions from business debt financing create all kinds of issues and potentially distortionate incentives that have been long-debated, but how things maybe should be is a different question from 'why are they how they are?'.

Personally I'd prefer a world of no income tax but only consumption and maybe some land and payroll taxes, in which case all this would be moot. But in an income tax system, giving deductions against income to equity becomes highly problematic.

Josh writes:

Maybe you've covered this, but wouldnt the better solution be to set the corporate tax rate to zero and make up the revenue with increased dividend and capital gains rates?

This would treat debt and equity the same, and also have the following added benefits:
1. No more "double taxation"
2. No more companies inverting or otherwise incorporating outside the U.S. to save on tax costs
3. No more companies leaving cash "trapped offshore" for fear of taxation upon repatriation
4. No more wasting private sector resources on trying to outsmart the corporate tax code, and no more wasting government resources trying to thwart them
5. No more confusion over Warren Buffet's "low tax rate" and other such nonsense
6. While this wouldn't be a tax on consumption, it would be a tax on consumers, which feels like a step in the right direction

Mark V Anderson writes:

I think Andreas has it right. We need to think of debtors as part owners, since they get the assets in bankruptcy. After all, most equity owners don't get the assets in most cases either, and their dividends are equivalent to interest. When interest is deductible to businesses, then it should be deductible to individuals too, since individuals borrow money to make investments in their life, essentially like businesses. Of course it used to be the case that personal interest was all deductible, at least if you itemized. Let's not go back there.

Debt and equity are qualitatively the same thing. The difference is that debt has guaranteed payments and a higher level of security against the assets. But capital doesn't have just two levels of guarantees and security; it is a continuum.

Allowing deductions for dividends makes it too easy for firms to manipulate their earnings for tax reasons, and it is also very hard to determine what deductions should be allowed for sole proprietors. Thus all payments and receipts of interest and dividends should be excluded from taxation. It should all come out even for the IRS, since both pluses and minuses are removed.

acarraro writes:

I think that the decision to make interest non-deductible would have the main effect of increasing leasing agreements or repurchase agreements. Most companies would transform most borrowing in renting/leasing agreements or modified implied lending/borrowing to supplier/clients. This would have little effect on the actual leverage, but just change the name of the contracts involved.

If you went full hog and made any rental/leasing/repurchase agreement non deductible (plus supplier or client finance I guess), it would be incredibly disruptive. It shifts the break-even point for a business. It extracts further tax from marginal businesses and is likely to increase bankruptcies I think. It basically forces lender to be much more involved with the borrower. Why would this be efficiency improvement? Why would reducing debt to GDP ratios be a good thing? I think most developed countries have higher level of debt. Why is it a bad thing? I don't see you justifying that statement.

I grant that it's somewhat consistent with ngdp targeting in some way. NGDP targeting is already shifting the cost of economic crisis on lender by shifting the unexpected shortfalls on lenders in part. That makes sense to me in a systematic level. Pushing the balance at the single business seems less reasonable to me...

Njnnja writes:

Interest expenses are expenses. They are subtracted from revenue (among other things) to get Net Income. To the extent that corporate taxes are intended to be applied to Net Income instead of Revenue, then you subtract interest expense to get taxable income (i.e., interest expense is tax deductible).

Note that there are some corporate taxes (I believe some Canadian life insurance or something strange like that) that are based on revenue, not net income. Obviously for that, interest expense is not tax deductible. But revenue taxes can be perceived as unfair because "it takes money to make money" so you can end up paying more in the revenue tax than you have left after paying for basic things like salaries.

Changes in capital are *not* a part of Net Income, whether you are talking about equity financing or debt financing. So if a company issues $100 million worth of stock, that *does not* count as $100 million of revenue, and therefore *does not* add $100 million to Net Income, and therefore *does not* increase taxable income by $100 million. Similarly, if a company pays a $100 million dividend to its equityholders, that *does not* count as $100 million of expenses, and *does not* reduce Net Income by $100 million, and therefore *does not* reduce taxable income by $100 million.

I think the confusion comes from the fact that people think of dividends on equity as being somehow similar to interest on debt, when from an accounting standpoint it is actually more like a payment of principal on debt - it is not a payment that is somehow "due" to shareholders, like expenses such as salaries or interest expense, but rather, a reduction in a balance sheet quantity (say retained earnings or APIC or whatever other equity account) like a debt raise or repayment.


tl;dr A dividend is like a very small return of equity and is more like a repayment of debt principal than it is a payment of interest on debt. Neither debt repayment nor equity capital returns are deductible because neither is ever part of revenue to begin with.

Phil writes:
"Phil, But why treat equity differently from debt?"

You're not treating equity differently from debt. Debt is really just equity with a fixed return.

Bob and Mary see a 10% business opportunity. They both contribute $500 equity. They each earn $50, which is taxed.

Bob and Mary see a 10% business opportunity. They both contribute $500. Mary is risk-averse, and demands a fixed 5% return regardless of how the business does. The business earns $100. Mary gets $25 of the profit (as agreed). Bob gets the remaining $75.

Mary's equity stake is called "debt" because her return is contractually fixed, but there's no real difference between them.

Mary's interest is "deductible" from Bob's profit for the same reason that, if she had been an equity partner, her share of the profits would be "deductible" from the total profit, with the difference being Bob's share.

Mark V Anderson writes:

Njnnja -- I am an accountant. It is true that interest has been treated as an expense on every set of financials I've ever seen. But I don't think this is anything more than a tradition. I don't see a substantial difference in kind between debt financing and equity financing. So payment for this capital should be treated the same for tax purposes.

It is true that eliminating deductibility of interest would result in all kinds of attempts to get around it with techniques such as leases. Actually, leases and other complicated capital maneuvers are already the focus of many accounting rules for both book and tax accounting. This is nothing new, although it would become worse. That is a downside.

I do think there is also a large upside to society if we don't allow interest deductibility. In my opinion, the Great Recession was largely caused by large and interlocking debt between companies. Our tax system encourages this use of guaranteed payments over the use of variable payments as done with equity.

Thomas B writes:

Njnnja,

You're right, there are some differences between my examples. It's possible to construct identical examples, but I didn't.

Nevertheless, the point is valid: business loans are simply a way to avoid raising equity capital; as such, they are effectively a way for the equity owners to finance the operations of the business they own, so that they themselves don't have to. The loan is a benefit to the equity owners, not to the business; and the interest on it should be viewed as an expense of the equity owners.

Whether that expense should be tax deductible or not, is another matter.

Mark V Anderson

Right on.

One thing I'm wondering, though: if interest wasn't deductible, people might lease more. But, the lease payment would be revenue to the leasing business, and essentially passed through to that entity's equity investors and lenders - both taxable. It's not clear to me that there would really be any tax avoidance here. Am I missing something?

Njnnja writes:

@ Mark V Anderson

I don't see a substantial difference in kind between debt financing and equity financing.

There is a huge difference in kind between debt financing and equity financing. Modigliani Miller doesn't claim that there is no difference between debt and equity financing, it just says that the value of the firm is not affected by debt versus equity financing. Debt is a contractual agreement with a defined return on capital and defined return of capital. Equity does not define when or where or how you will ever get a return or if you will ever get even your original investment back.

As an accountant, I'm sure you are well familiar with examples where a company makes a promise to do something fairly specific and well defined in the future, whether it is an account payable or a postretirement benefit, and the portion of that promise accrued in the current period is estimated and expensed today. That is like interest expense. But for something where there is no promise, like equity, there is no accrual.

Also, see my earlier comment about the difference between return *of* capital and return *on* capital. A company never pays out a return *on* equity capital, it can only make a return *of* equity capital (through a dividend or share buyback). However, it can (and does) pay the return *on* debt capital through interest payments. If return *of* debt capital doesn't go through I/S then neither should return *of* equity capital. That is another difference.

AS writes:

Interest should be deductible to obtain equivalence between leasing and mortgage. If interest wasn't deductible, all businesses would arbitrarily try to lease instead.

The real question is why businesses are taxed at all. Business income is already taxed as personal income when it is eventually disbursed to the owner. Dividends, as well as capital gains (i.e. all corporate income) should be deductible; in other words, the corporate tax should be eliminated and simply replaced with income tax.

derek writes:

Because debt is a service that costs money. Equity is ownership. There are no costs involved in dividends because it is the distribution of profits to the owners.

The service debt provides is to turn illiquid equity into cash. Existing equity may be tied up in land or some illiquid asset, the lender provides a service to turn it into cash for some business operation. At a price.

Your question is why is it cheaper to raise capital by borrowing as opposed to issuing shares. Your immediate response is to raise the cost of borrowing. I'd ask why is that your prior as opposed to figuring out the reasons why equity costs more?

And by the way, are the costs to issuing shares and doing all the corporate and regulatory stuff required tax deductible? The people doing that sort of stuff are a substantial chunk of the economy, so presumably there are real costs involved, and as shown by the bias towards debt, higher than the interest costs of borrowing.


Comments for this entry have been closed
Return to top