My favorite news magazine, The Economist, has a cover article this week entitled "The Great Distortion" portraying "tax-free debt" as "the dangerous flaw at the heart of the world economy". In their usage, "tax-free debt" refers to residential mortgage debt and business debt on which interest payments are deductible (not, as an American taxpayer might think, tax-free state and local government debt which is literally tax-free to the holder).
Unusually for this sophisticated magazine, the article seems to have a poor understanding of the underpinning of the tax deduction for interest expense incurred by businesses, so I am putting up this post to address that.
The characterization of mortgage and business debt as "tax-free" is a good example of their confusion. Neither residential mortgage debt nor business debt is tax-free to the holder, as long as the holder is a taxable entity. The beneficial holder of a mortgage / MBS or a loan / loan fund will have to treat the interest payments received as ordinary income under US tax law. The payor is allowed to deduct those payments. This is the principle of "matching" that is fundamental to income taxing systems and is not at all unique to either the US or debt setvice payments. For example, if a retailer like Target buys 100 Wrangler jeans from VF Corp., the retailer deducts the cost of the jeans as an expense and VF Corp records the sale as gross income, against which it has its own deductions, resulting in the profit being taxable income.
If we change the jeans to interest on a loan, the treatment should be the same, at least in a business context. The lender records the payment as gross income, against which it nets its own costs, and reports a profit that is taxed at ordinary income income tax rates (and there can be further taxation if the lender is a C corporation and remits any of its profits to its holders). The business that borrowed the money records the interest payment as a deduction and that just mimics the tax treatment of the jeans.
There is no reason to treat a business's interest payments differently than any other expenses it incurs. A business may borrow to buy inventory or equipment. Its sellers may finance those purchases with an explicit interest charge. Or they may give a discount for payment made within X days, which is just an interest charge stated in different words. For bigger-ticket items, there may be a multi-year installment payment schedule, with or without an explicit interest rate, and there are rules for figuring out the unstated interest and related tax issues. The equipment may be leased instead of sold outright; the lease, as anyone who has leased a car understands, will embed an interest rate of some size. So there are numerous conventional and uncontroversial ways in which the cost of money can enter into the sale of goods and other assets and it is more consistent and efficient to accord the finance cost the same treatment as the sale it pertains to, than to try to break it out and apply a radically different treatment.
The article argues that, as it is difficult to eliminate tax preferences, it would be systemically healthier for the global economy to afford a comparable tax break for payments to equity holders. They note that, beyond equalizing owners' preferences for debt vs. equity, such a tax break would offset the problem of "double taxation" that burdens business owners with taxation of income at both the corporate and the owner level. Although double taxation is certainly a flaw and distortion of economic activity, I disagree with the proposed solution, as I find it overly clumsy and distorting.
Interest on business debt is deductible because, as shown above, it is a cost of business incurred by the business owner, directly if the business is a sole proprietorship, or at a remove through a business entity in which the owner holds an interest. An equity distribution is not a cost incurred by the business owner. It is net income, exactly the opposite. Sometimes this proposal is rationalized by characterizing the equity distribution as a payment by the corporation for the funds provided to it by the equity owners and thus a classic business expense. That is a flaw, in my view. A corporation in and of itself has no intrinsic reason to receive or disburse funds. It is just a shell. It is the owners who want the corporate entity to have funds and operate. Business entities are better seen as proxies for the owners. If they are taxed, it is justifiable only because it is more efficient than to tax the owners (e.g., because the owners are tax-exempt or reside somewhere beyond the taxing authority's jurisdiction, or because the records are all kept at the corporate level and are more easily processed there). It is better analysis of economic substance to see all the expenses of a corporation as expenses of the owners through a proxy. In that light, interest is deductible, while equity returns are not.
By the same logic, residential mortgage interest should not be deductible, because it is just funding a consumption purchase, not the income generation of a business that borrows. It is an unfortunate relic of a politically motivated encouragement of postwar middle-class consumption.
Although there should not be double taxation of business income, giving a tax break for income distributions to equity is not the way to fix that. The simplest way is to make all business entities pass-throughs, like REITs, partnerships, LLCs, S Corps, mutual funds, hedge funds, MLPs, etc., and eliminate tax-exempt treatment of investment income received by not-for-profit organizations. The second best way, if one cannot accept eliminating the present disparate tax treatment of for-profit and not-for-profit corporations, is to give each business owner an income tax credit equal to his or her proportional ownership share of any income taxes paid by the corporation in which he or she has a stake. The not-for-profit holders would not be able to use it, but neither do they pay income taxes on corporate distributions in the first place. See this brief article for an overview of the problem and solutions.
Further, corporate debt is not a systemic problem. This is because of (1) the operation of chapter 11, in particular the absolute priority rule, and (2) stiff margin requirements for private sector debt and equity holdings. Chapter 11 enables business debt to be converted to business equity, minimizing losses to the debt holders, while shifting the losses to the pre-restructuring equity holders. In turn, the stiff margin requirements (minimum 50%) for holding equity of public corporations ensures that, if and when losses hit the equity holders, they absorb it and do not pass them on to their lenders. Also, the risk capital weightings are higher for private sector debt than for other types of debt so there is an additional layer of buffer in the financial system for the risk of private sector default.
The residential mortgage sector unfortunately has not had these protections. In particular the margin requirements, and the regulatory capital requirements, for holding mortgages and MBS were woefully inadequate, always less than 10% and often less than 5%, which left the financial system exposed to massive losses when housing prices fell more than the margin / capital buffer.
The real issue with debt is not its tax-free-ness but the risk of incurring too much. Tax deductibility is a small factor in increasing that risk, but the larger one is too liberal margin and capital requirements, and the residential mortgage sector is a particular source of that risk.
