U.S. Tax Code Favors Debt

Excerpt from an article in

The New York Times

Wednesday, February 29, 2012

U.S. Tax Code Encourages Corporations to Take on Debt

By STEVEN M. DAVIDOFF

Corporate America's love affair with debt is driven by a heavy subsidy, courtesy of the federal tax code. It's an unhealthy preference that the Obama administration is now reviewing.

The problem arises because the interest that corporations pay on their debt is deductible on their federal taxes.

To understand the effect of this deduction, imagine if you could deduct the interest you pay on your debt. I am not just talking about the deduction on your home mortgage. This would be a deduction for all of the interest paid on your credit card bills, auto loans and any other loans you had, including the one from Uncle Mikey.

What would be the effect? First, you would have more money in your pocket. That 10- or 15-something percent interest rate on your credit card would be effectively reduced by up to a third, depending upon your tax rate.

But because debt is now cheaper, you may be more likely to borrow to make purchases rather than purchase items outright. If so, you would end up taking on more aggregate debt and saving less. Before the 1986 tax overhaul, credit card interest could in fact be deducted. Congress eliminated this loophole, in part, because members thought it encouraged just this sort of behavior.

This is what is occurring in corporate America. Companies can finance investment from either debt or equity. But profit on an investment financed with equity - stock issued by the company - is taxed. In contrast, if the project is financed with debt, then only the profit after interest payments are made is taxed. This means debt-financed investments are cheaper than equity.

This creates a bias by corporations toward debt.