From the Fair Tax.org:
Could heavy corporate debt and an underperforming economy be traced back to your tax dollars?
An intriguing article published on the popular investment site, The Motley Fool, details a huge problem with our current tax code and makes this point.
The article, Stop Bribing Companies to Lever Up, lays bare the backwards logic of our government essentially bribing American companies – with your tax dollars – to finance corporate investments with debt. It begins:
Go ahead and pull out an income statement for your favorite stock. I’ll wait.
You’ll notice that there is a line called “Interest Expense” that comes before the “Tax Expense” line. Now notice the absence of similar lines for “Dividend Expense” and “Share Buyback Expense.”
No, I’m not trying to bore you with an accounting lecture. I’m trying to point out a travesty of modern finance: the unequal treatment of debt and equity, better known as the tax-deductibility of interest.
Thanks to interest deductibility, our tax code unfairly benefits companies that lever themselves to the moon — e.g., big banks — while putting those who choose equity financing — like Apple — at a comparative disadvantage.
And the disparity is real. The Congressional Budget Office finds that equity-financed corporate investments pay an effective tax rate of 36.1%, while debt-financed investments pay an effective tax rate of -6.4%.
Yes, that’s a negative tax rate for debt-financed corporate investment. Taxpayers are paying corporations to lever up. It’s totally unfair and unwise.
And then we all sit around and wonder why banks levered themselves 1000 to 1. Why, the tax code pays them to!
As a rule, in order to grow a business and create jobs business owners are faced with a financing decision: growth by debt or by equity? Debt involves borrowing money that must be repaid with interest. Equity involves raising cash by selling interests in the company.
Current law places a lower tax burden on firms that use debt financing than on those that use the equity market to finance new projects. Thus, projects that would not be economical in a no-tax world might become viable as a result of the tax subsidy.
For an equity-financed company, however, a very different picture emerges. For a company that issues equity with a required rate of return to investors of 10%, that equity costs them10%. There is no tax deduction.
A universally accepted tenet of good tax policy is that a tax system should be neutral as to t its effect on a taxpayer’s decisions regarding how to carry out a particular transaction. In other words, tax policy should not distort economic decisions.
The FairTax Plan, by eliminating the corporate tax and its complicated distinctions between debt and equity finance, removes the tax system as a distortionary factor in the financing decisions made by businesses.
It also eliminates the incentive for firms to increase their debt load beyond the amount dictated by normal business conditions. And, to stimulate job creation, the FairTax takes the US from its perch atop the ranking of corporate tax rates to the bottom.
The Motley Fool writer, Chris Baines added:
“Under the FairTax, the corporate income tax, dividend tax, capital gains tax, payroll taxes, and individual income taxes (including any taxes on interest) would be completely eliminated. Instead, a national sales tax of 23% would be levied on all new goods and services. An “advanced refund” mechanism would also be put in place to ensure that the tax does not hurt those below the poverty line. I’m not the best one to explain the details, so I recommend checking out the FairTax website.
If nothing is taxed besides sales, there can be no perverse tax incentives to lever or delever. Debt and equity are truly on an equal footing, as they should be.”
We couldn’t agree more Mr. Baines.