There are many reasons tax reform remains a distant dream. Not “tax reform” disguising a tax hike as the Obama Administration envisions, but tax reform that would make U.S. companies and workers world-class competitors, ferret out tax cheats, and make paying taxes a little less onerous to taxpayers. Perhaps the most frustrating reason real tax reform cannot gain traction was on display in The Washington Post over the weekend.
In the Post’s business section there appeared an article on why businesses in America are so enamored of debt. The article argued that businesses take on so much debt because of powerful incentives in the tax code, especially the deductibility of interest expense.
Defining terms for a moment, an “incentive” is a policy that causes you to do something you otherwise wouldn’t. In tax policy, it means you’re encouraged to do something or to do something in greater amount by the tax system that you would not do if you were not subject to the tax code at all. The ethanol tax credit is a tax “incentive.” The exclusion for employer-provided health insurance is another.
Calling the deduction of interest expense an incentive is wrong for two simple reasons relating to Income Tax 101. The first is that under an income tax, a business is allowed to deduct its expenses in calculating taxable income. Interest is a normal business expense. It should be deductible. There’s no incentive here.
Second, as our income tax is constructed, interest income should be taxable and interest expense should be deductible. This symmetry establishes neutrality. Take away the deduction for interest expense and you’ve not eliminated an incentive; you’ve created an artificial disincentive.
To be sure, there is a bias in the tax code in favor of debt, but it arises not from deducting interest but from overtaxing corporate equity, especially through the taxation of dividends and capital gains. Note that Obama has proposed raising the tax on dividends and capital gains, and Congress is readying a vastly greater increase in the taxation of dividends. So Obama’s proposals would exacerbate the bias in favor of debt. Curious these points were not mentioned in the Washington Post story.
It might be forgivable that a story about the taxation of business could get such simple points so wrong if the story appeared in the Style section, or maybe the Food section. But it didn’t. It was the main story in the Sunday Business section. No wonder our tax system continues to bedevil our economy, and no wonder it is likely to continue to do so for many years to come.
