Why not treat debt and equity the same?

Varun, a loyal MR reader, asks me:

I do have a fairly simple question on tax policy I’ve never really seen a good answer to:  Why do we treat interest payments differently in terms of taxation? Why are interest payments tax deductible?
Clearly a zero corporate tax rate is best, but why do we offer tax shields for highly levered companies? All of private equity, and much of banking etc. is built on this tax arbitrage. Wouldn’t treating interest payments on par with dividends and corporate profits (hopefully at a lower tax rate) unlock a great deal of value, drive an increase in (stock) investment, while significantly un-levering businesses? Why do we borrow when we can seek investment?
More importantly, isn’t it odd that few advocate such a simple policy change: to treat debt and capital investment identically.
A good question, but there is a problem with treating debt payments any other way.  In general, expenses must be deductible in some manner, if the government is to tax corporations on net rather than gross returns, however roughly or imperfectly.  And it is difficult not to treat interest like an expense of some kind.  For instance de facto interest could be embedded in repurchase agreements, which for the purposes of tax law would look more like “real expenses” and thus would be tax deductible.  The borrowing would still go on, but in a more awkward fashion.
Without tax deductible interest payments, there would be an excess incentive to pay cash up front for assets rather than doing a mix of borrowing and holding cash for option demand.  Corporations would go bankrupt more easily and in general face higher transactions costs.

Contrary to common impression, the tax deductibility of interest payments does not give a tax advantage to borrowing, not if the return to savings is taxed.  What you save by borrowing and writing off interest payments you pay back tax on your more liquid asset holdings; admittedly there are complications and wedges when lending and borrowing rates are not the same.  Therefore tax-deductible interest payments makes tax law roughly neutral in intertemporal terms, with lots of qualifications tacked on to that claim, including the possibility that some corporations can avoid the taxes on liquid asset holdings altogether.

The tax deductibility of interest payments operates in a highly imperfect manner, but at its core it is a piece of what an ideal (roughly) neutral tax system would look like, not a deviation from such neutrality.


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