Sen. Elizabeth Warren has made private equity companies a villain of her presidential campaign, and has introduced a big plan to try to punish them. While a lot of her criticisms of the industry are wrongheaded, private equity firms do benefit heavily from a tax code that allows for the deductibility of interest payments. Warren includes a reference in her plan to going after tax breaks that private equity companies could get from debt they add to the companies they acquire.
Instead of these proposed rules targeting a specific industry, Warren should advocate a change in the tax treatment of interest payments broadly, and sell it (not dishonestly) as a tax increase on private equity.
It would also have the added benefit of blunting the impact of the next recession – a threat that some economists have grown increasingly nervous about lately.
Surprisingly, federal tax policy helps to stack the dominoes that could exacerbate the next recession.
As economist Alan Cole wrote in American Affairs in 2018, before the Tax Cuts and Jobs Act (TCJA), corporations have been able to deduct interest payments (the cost of raising capital to finance investment by borrowing money), while corporations have not been able to deduct dividend payments to shareholders (the cost of raising capital through equity). As a result, the tax code creates a bias in favor of corporate borrowing.
As of the first quarter of 2019, U.S. companies hold over $9 trillion dollars in debt, and according to Deloitte, corporate debt levels are higher than they were before the Great Recession. The concern here is that rising corporate debt, particularly “junk” or higher-risk bonds, could lead to higher rates of default in the next recession. A collapse in earnings could force more companies to default thanks to the tax-induced overreliance on debt financing.
A paper in the Villanova Law Review also found that the corporate interest deduction reduces innovation by incentivizing companies to pursue lower-risk, lower-growth projects.
The TCJA made some changes. The tax reform limited the deductibility of corporate interest payments to 30 percent of a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) until 2021, and to 30 percent of earnings before interest and taxes (EBIT) afterwards. However, these changes haven’t proved as effective at curbing corporate borrowing. As Lydia O’Neal atBloomberg Tax reported, exceptions for certain industries that rely heavily on debt financing have dampened the effectiveness of this limit.
Going forward, lawmakers should consider expanding and strengthening the TCJA’s changes. One strong policy idea (one I’ve written about in Pursuit before) would be to end both the taxation and deductibility of interest payments. This proposal would raise a lot of tax revenue ($721 billion according to a pre-TCJA model, although likely significantly less thanks to the reduction in the corporate tax rate), mostly from higher-income earners, and wouldn’t significantly hurt economic growth. How? Because under current law, a lot of interest income already goes untaxed, as it is received by tax-exempt organizations and foreign persons.
A policy like flipping the tax treatment of corporate interest could help raise a lot of revenue to help reduce the deficit while holding appeal across party lines. It could also soften the blow of the next recession.
