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US business investment—including research and development (R&D) outlays to create intellectual property—hasn't exactly sparkled in recent years (figure 1). Anemic investment is a key reason that US GDP lags 3.6 percent below what economists see as potential output, and the US economy is chugging along at under 2 percent average annual growth. Under these circumstances, the US Treasury ought to be exploring imaginative tax reforms that would spur business investment.1 Instead, the department is busy writing new regulations that will dampen investment. The latest measure characterizes certain debt instruments as equity shares and thereby denies the deduction of interest payments when calculating taxable business earnings. Treasury's hope is to collect more tax revenue from business firms, but its approach is misguided and counterproductive.
Before delving into this attack, it's worth explaining why high statutory US corporate tax rates (39.6 percent, combining federal and state taxes, versus an average statutory rate of 26.6 percent among competitor countries) send only a trickle, not a flood, of business firms overseas to relocate in friendly tax jurisdictions. The core reason is that the US Congress, in its wisdom, has provided many avenues to lighten the burden of high nominal business tax rates. For example:
- Creation of "pass-through" entities, which are not taxed at the business level. Instead, "pass-through" earnings are attributed to households and taxed as personal income. Consequently, whereas standard Subchapter C corporations accounted for 75 percent of US business income in 1980, today they account for only 36 percent.
- Immediate expensing of R&D outlays and "bonus depreciation" of half of plant and equipment outlays. These provisions accelerate the tax benefits of undertaking new investment.
- Deduction of interest payments in calculating taxable income. The deduction enables firms to use borrowed funds at no tax cost, unlike earnings on equity capital, which are subject to corporate tax.
Despite these and other avenues for lightening the business tax burden, the US effective corporate tax rate remains significantly higher than the average effective rate imposed by peer industrial countries: 28.1 percent versus 17.2 percent.
Ignoring the large corporate tax rate gap between the United States and its competitors, both in statutory and effective rates, Treasury's new policy takes aim at the deduction of interest payments. An old and principled argument for denying a deduction for interest payments holds that differential taxation of debt and equity prompts firms to put too much debt on their balance sheets. But of course the right answer to this argument—in light of global competition—is to lower the tax burden on equity. Treasury did no such thing. Instead, Treasury simply raised the tax burden on debt.
Internal Revenue Code Section 385 gives the Treasury broad discretion to issue regulations that characterize certain forms of debt as equity. Treasury has now used this discretion to characterize "excessive" debt between related firms as equity, with the result that the interest payments in question are regarded as dividends and are no longer deductible by the paying firm in calculating its taxable income.
The new Treasury regulations were solely motivated by tax collection concerns. First, an apprehension that US subsidiaries of foreign firms are engaging in "earnings stripping," namely "loading up" on debt to related firms abroad and paying tax-deductible interest rather than declaring taxable earnings. Second, the fear that the same practice facilitates "inversions" by multinational corporations (e.g., moving the parent firm from New York to London).
Treasury's fears, bolstered by pejorative labels, are misplaced. Ample research shows that foreign firms operating in the United States are great corporate citizens. They employed over 6 million Americans in 2013, and they pay higher wages and conduct more R&D than their US counterparts.2 One reason the United States attracts so much inward foreign direct investment (FDI)—a stock totaling $3 trillion in 2014—is that Congress has enacted multiple avenues of relief from high statutory corporate tax rates, including the deduction of interest payments. Instead of narrowing this particular avenue of relief, the Treasury should welcome the high-paying jobs and personal tax receipts that come when foreign multinational corporations set up shop in America.
As for "inversions," with this and other regulations, the Treasury is applying band aids to an illness that requires surgery. The US corporate tax rate and the US worldwide tax system are out of step with global norms. Rather than building a tax wall in an effort to keep firms at home, the Treasury should fundamentally reform taxation of business activity to make the United States a competitive and attractive location for US and foreign firms alike.
Notes
1. Several proposals are outlined in a series of blogs on business tax reform, available here.
2. US Bureau of Economic Analysis, "Foreign Direct Investment in the US, Majority-Owned Bank and Nonbank US Affiliates (data for 2007 and forward), Employment."
