#CorporateTaxFramework: Attack on Debt and Depreciation

The positive reaction to the “Framework” plan on corporate tax reform released this week by the Department of Treasury and the White House has been underwhelming. Most have dismissed it as a political document, unlikely to be seriously considered this year. However, it needs to be read closely as it reveals the thinking of the Administration and may portend of things to come if returned next year for another four-year term.

The previous rendition on the Framework left a few things out but they are important to note. The first is the direct bias against debt financing that can be described as a desire to raise more tax revenue by curtailing the deductibility of interest to pay for other favored causes.

The current corporate tax law makes a distinction between the use of debt financing and equity by a company. Corporate dividends are not deductible from corporate taxable income, but interest payments are. This difference makes a big impact on how a company views obtaining funds for all kinds of business purposes--such as plant expansion, working capital, or an acquisition.

Profits generated by an equity-financed investment will be taxed at the 35 percent corporate rate, leaving 65 percent of the profits for dividend payments to shareholders. Dividends are currently taxed to the shareholder at fifteen percent but this rate will expire at the end of this year. The Administration favors a much higher rate, which could exceed forty percent. In contrast, profits funded by debt will only be taxed to the extent they exceed the associated interest payments on the money but the receipt of the interest is taxed at the marginal rate paid by the recipient. 

The Framework states in part: “Once the deductibility of interest is combined with accelerated depreciation, the cost of debt capital”…. (is lower than equity)

This may be true except the statement fails to mention equity funds can also be used to acquire a depreciable asset and in the case of equity, the funds do not have to be paid back. The Framework is making selective omissions when it is trying to make a point.

The Framework goes on to say: “tax preference for debt financing has important macroeconomic consequences. First and foremost, outsized reliance on debt financing can increase the risk of financial distress and thus raise the likelihood of bankruptcy”

Financial distress can also be caused by bad management, horrible markets, increased competition and excessive government regulation, which hampers the business. The Treasury document concludes by saying  “a large bias towards debt financing in the corporate tax code may lead to greater aggregate leverage and the associated firm-level and macroeconomic costs of debt financing.”

So, how does the Obama Administration want to eliminate the evils of debt?” Simple, get rid of the deductibility of interest. To wit: “Additional steps like reducing the deductibility of interest for corporations should be considered as part of a reform plan.”. The report further states, reducing the deductibility of interest for corporations could finance lower tax rates and do more to encourage investment in the United States than keeping rates higher or paying for the rate reductions in other ways.

In other words, the target is to curb the interest deduction. Seems plain to me. It is not to address the deductibility of dividends or the double taxation of dividends. It is to impose a judgment of the government on how a business is structured. Watch out on this one.

The other point of interest contained in the Framework concerns depreciation. Amortization, depreciation, or, when I was in school it was called, the capital consumption allowance is merely a schedule of how a business recoups the cost of plant and equipment.

Buy a pencil, you write it off as an office supply. Buy a wrecking ball, for example, (and I used to own an interest in one long time ago) and the company can only deduct only a potion of the cost each year so at the end of the useful life of the asset; the company has recouped its cost. The depreciation allowance is taken every year under statutory guidelines for the most part issued by the government. This is a principal of the income tax system from inception. 

 However, the Framework declares: ”Current depreciation schedules generally overstates the true economic depreciation of assets. Although this provides an incentive to invest, it comes at the cost of higher tax rates for a given amount of revenue. In an increasingly global economy, accelerated depreciation may be a less effective way to increase investment and job creation than reinvesting the savings from moving towards economic depreciation into reducing tax rates.”

This is revealing and a bit of slight of hand. It is also nonsense.  On one hand the Administration has been supporting “bonus depreciation" allowances and expensing for small businesses. Now comes the revelation, depreciation is bad, evil—if we could just cut it back, then we could lower rates and direct more subsidies to the chosen industries, like clean energy.

I believe quick amortization is an effective tool to stimulate investment, plant modernization and replacement.  Depreciation is a recovery process; it affects the timing not the amount that is recovered. This is a critical area and the Administration's signal to decrease it is not only perplexing but should be worrisome.

The positions taken by the Administration on the interest deduction and depreciation allowances are very telling. It is part of a philosophy of favored winners being chosen by this government and letting the rest of the crowd standing at the side of the road while the bus drives by.