Eliminate the Deductibility of Business Interest and Exempt Interest Income from Taxation

The US tax code treats debt and equity financing differently, generally favoring debt as businesses can deduct their interest payments to debtholders (subject to a limitation) but not their dividend payments to stockholders. Beginning in 2018, the Tax Cuts and Jobs Act introduced a new limit on the deduction for business interest paid of 30 percent of EBITDA (earnings before interest, taxes, depreciation, and amortization), intended to reduce the tax code’s bias for debt over equity. At the individual level, interest income received is taxable, and at higher rates than dividends, but in practice, a large share of business debt is held by tax-exempt entities or foreigners. The result is a relatively large gap in the income tax and a preference for debt over equity financing.

This option reverses the status quo. Rather than partially limiting interest deduction and partially taxing interest income, it would make interest paid by businesses non-deductible and interest income received non-taxable. By effectively ignoring interest paid and received, the tax system would no longer favor debt financing and would be much simpler. Flipping the treatment of interest would, however, increase the cost of capital by removing the current subsidy for debt financing, reducing capital investment and economic output.

On a conventional basis, this option would decrease the primary deficit by $581.3 billion over the budget window. Long-run GDP would fall by 1.6 percent, and long-run GNP would fall by 0.9 percent. On a dynamic basis, the primary deficit would increase by $364.3 billion from 2027 through 2036, $945.6 billion less than the conventional estimate. Incorporating changes in interest costs, the publicly held debt-to-GDP ratio would be higher than baseline, reaching 182.7 percent by 2056.

On average, in 2036, taxpayers would see decreases in their after-tax incomes of 0.5 percent. The top quintile of taxpayers would experience a 0.6 percent decrease, whereas the bottom quintile would experience a 0.4 percent decrease. On a long-run dynamic basis, taxpayers would see a 1.8 percent decrease on average.