As I watch the current situation in Washington, D.C., I am reminded of the line from Alice in Wonderland: “It just gets curiouser and curiouser.” While the machinations in the Trump White House and Congress are the subject of much water cooler discussion, I am alarmed at a proposal being bandied about by Republican members of the U.S. House of Representatives, an idea that I believe looks like something out of a Lewis Carroll novel.
Republicans looking to rewrite the U.S. tax code are taking aim at one of the foundations of modern finance: the deduction that companies get for interest they pay on debt. That deduction affects everyone from titans of Wall Street who load up on junk bonds to pay for multibillion dollar corporate takeovers to wheat farmers in the Midwest looking to make ends meet before harvest.
In our own industry, where capital expenditures on plant, equipment, and rolling stock are critical to financial success, this could be a devastating setback. Yet the proposal to eliminate the deduction has received little public attention or lobbying pressure.
Because of this deduction, the U.S. financial system is heavily oriented toward debt, which because of the tax code, is often cheaper than equity financing, or the sales of stock. In 2015, U.S. businesses paid $1.3 trillion in gross interest, according to the Commerce Department, equal in magnitude to the total economic output of Australia.
Reducing debt financing
But getting rid of the deduction for net interest expense would alter finance. It also would generate about $1.5 trillion in revenue for the government over a decade, so the plan would raise money to help offset Republicans’ corporate tax cuts, while simultaneously reducing a bias toward debt financing.
Rep. Kevin Brady (R-Texas), author of the plan, proposes eliminating the incentive from the source of funds, or borrowing, and move that preference to the use of funds, such as business investment, buildings, equipment, software, and technology. So the Republican plan is to pair eliminating this deduction with immediate deductions for investments in equipment and other long-lived assets.
Proponents think the capital write-offs would encourage more investment and growth, as well as greater worker productivity. In a world with no interest deduction, debt-fueled leveraged buyouts by private-equity titans could become more expensive to finance, and junk bonds would become less appealing.
Republicans aim to agree on a framework for tax policy by September and send a bill to the President this year. It will be an uphill fight and companies who want to keep the interest deduction will have plenty of clout. From an accounting standpoint, the tradeoff could hurt reported earnings by companies, because immediate expensing would just shift the timing of deductions, and the loss of the interest deduction would be a permanent change. But borrowing and deducting interest are deeply ingrained in U.S. corporate finance as a normal cost of doing business, so dislodging the traditional practice will be challenging.
This could get messy
Because so much is at stake for so many sectors, writing the law could get messy. Some speculate that small businesses and utilities could get exceptions or specialized rules, as could debt-financed purchases of land, which wouldn’t be eligible for immediate investment write-offs. The administration has been wary of repealing the interest deduction, but hasn’t drawn a hard line. Resistance could build among Republicans in Congress and among real estate firms and the agriculture industry, which have formed a coalition to fight the proposal.
Without repealing the interest deduction, Republicans’ hopes of providing full and immediate deductions for capital investment are dim, as they wouldn’t have enough money to offset the upfront fiscal cost of accelerating those deductions. But limits on interest and accelerated write-offs could be dialed in to a politically comfortable spot. If Republicans can’t stomach fullly repealing the interest deduction and immediate write-offs, they could try something short of that with half of capital expenses being deductible and half of interest being deductible.
The interest expense deduction is a key factor in our industry’s profitability, and I am not in favor of this proposal. Let’s hope the lobbyists who are battling for keeping this tax benefit prevail.