Why Do We Encourage Corporate Debt?

I'm always pleased to hear genuinely good ideas. In perusing Felix Salmon's Reuters blog this morning, I came across a brilliant one. It's actually one that's being considered by Paul Volcker's tax policy panel. Coincidentally, I wrote about another of Volcker's ideas earlier from a New York Times article, which I wasn't as excited about. The one I like is mentioned by the Wall Street Journal, in an article with an entirely different focus. The particular part that I'm intrigued by would end interest tax deductions for corporations.

Here's the Journal:

Tax experts for decades have bemoaned the tax code's bias toward debt over equity: Interest on most corporate debt is tax deductible, while dividend payments are not.

The essential question here, I think, is: why do we have a system that encourages corporations to take on more debt instead of equity? It seems completely counterintuitive to how businesses should seek to operate. The WSJ explains this:

"The disparity between debt and equity financing encourages corporations to finance themselves more heavily through borrowing. This leverage in turn increases the financial fragility of the economy, an effect we are seeing quite dramatically today," Jason Furman, now deputy director of Mr. Obama's National Economic Council, told a congressional panel last year.

To which Salmon adds:

This is something I've been pushing for a while, and it's a really good idea. As the WSJ article shows, the US, with its 39.1% corporate tax rate, manages to raise just 3.2% of GDP through corporate taxes. Meanwhile, Australia, with a 30% corporate tax rate, raises 6.6% of GDP from corporate taxes. If Volcker starts taxing debt as well as equity, that would do wonders for the US fisc, and would reduce the systemic danger that debt poses to the economy. What's not to love?

I can think of two reasons why the government might want to encourage debt. First, it's a nice little payback to banks for their campaign contributions support. Second, and more legitimately, it might help businesses, particularly small businesses, flourish. It reduces capital costs.

The first reason is obviously not a good one, but the second matters. I'd be specifically concerned with small businesses that rely a lot more on debt than equity. By allowing them to deduct interest from their taxes, this makes their debt a lot less costly, allowing better profit and growth.

But if it's small business you're looking to help, there are other ways to do this. Maybe you can have a relatively low cap on the amount of interest you can deduct from taxes. Or maybe you can have a cap on the size of the firm or age limit for when interest can be deducted. Such exceptions would seek to allow the new dry cleaner that just opened on your block to take advantage of tax credits but not General Electric

Meanwhile, it would be great for the equity market if dividends were tax deductible instead. There's little doubt that it would make the bulls run wild. But this would seek to balance out investing a little too. Creditors would still have a higher priority upon bankruptcy, so debt would still be safer. Meanwhile, equity investors would have better prospects for dividends, if tax deductible.

Clearly, such a move would drive banks crazy. They love making money off issuing corporations debt. But that's hardly a reason to uphold a policy that encourages firms to gravitate towards a riskier funding option. Debt shouldn't be eliminated, but it also shouldn't be encouraged.