By Benn Steil and Emma Smith, Council on Foreign Relations Geo-Graphics blog
Donald Trump famously called himself “the King of Debt,” but his tax plan would actually wipe out the biggest incentive he has to leverage his kingdom—the incentive built into America’s perverse corporate tax code.
Owing to interest tax-deductibility and accelerated depreciation for debt-financed investments, U.S. corporations face an astounding 38.2 percentage-point effective tax-rate penalty for equity-financed investments. These are taxed at 30.8 percent, while those that are debt-financed are subsidized to the tune of -7.4 percent. This naturally encourages companies to operate at artificially elevated levels of leverage, which makes it more likely they will experience financial distress.
Over the past five years, U.S. companies have been loading up on debt. As the left-hand side of the graphic above shows, non-financial corporate debt as a share of GDP is back at its 2009 peak. Leverage is also at a record high.
Trump’s tax plan would eliminate some big corporate tax incentives to leverage. He would allow firms to deduct capital investment from their income immediately, irrespective of whether it is debt- or equity-financed, as an alternative to deducting interest payments. Coupled with his headline tax-rate cut from 35 to 15 percent, the plan would take the average effective rate on both debt- and equity-financed investment to around 10 percent—as shown on the right-hand figure above. Hillary Clinton’s tax plan, in contrast, leaves the tax subsidy for debt financing in place.
But Trump has proposed that only capital investments—such as machinery, equipment, and buildings—be eligible for immediate deduction. As a result, firms that borrow predominately to finance other expenditures—notably banks, which use leverage to issue loans and buy financial assets—will continue deducting interest.
New regulations introduced after the crisis have forced banks to deleverage some. But they remain far more highly leveraged than non-banks, and as long as there remains a massive tax benefit for debt they will find ways to arbitrage rules and minimize their cost of capital—irrespective of the harm to financial stability. For the tax system to encourage banks to switch from debt to equity financing, therefore, either interest tax-deductibility or taxes on equity-financed investment will have to be cut.
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EDITOR'S NOTE
This is a Hedgeye Guest Contributor research note written by Benn Steil and Emma Smith for the Council on Foreign Relations. This piece does not necessarily reflect the opinion of Hedgeye.
