Industry challenges Obama on debt tax shield

Weakening the tax deductibility of interest payments could effectively raise the tax rate on new investment, in turn weakening a still fragile economic recovery, according to a study conducted by Ernst & Young and backed by the Private Equity Growth Capital Council. 

Back in February President Obama proposed a slash in the corporate tax rate from 35 percent to 28 percent in exchange for (undefined) limits to the deductibility of interest expenses. Subsequent legislation in Congress put a hard number on Obama’s proposal, lowering any interest deduction to 75 percent from the current 100 percent available offset on corporate taxes. 

With those numbers in mind, the study concluded that a company’s marginal effective tax rate (METR) would in fact climb to 33.1 percent from 31 percent. “This significant increase in the METR indicates that business investment would decline in response to lower after-tax returns. The resulting lower level of investment would have the potential to impede rather than encourage economic growth.”

The METR provides an estimate of the tax cost of a hypothetical marginal investment over its life. The METR can be viewed as measuring the additional economic income a marginal investment needs to earn to cover taxes over its lifetime, explained the study. 

The White House is arguing the current corporate tax code encourages excessive debt in businesses’ capital structures. The study countered that the tax bias for debt financing is unrelated to the deductibility of interest payments, but instead has at its root causes the difference in tax rates faced by borrowers and lenders and the double tax on corporate profits.