Interest is an operating expense that is incurred in the ordinary course of a trade or business and is appropriately deductible under the tax code. Interest expense, simply put, is the cost of borrowing money, and it is paid by virtually any company that funds a portion of their operations with debt.

Although private equity firms and funds generally have little to no leverage, some private equity portfolio companies do utilize debt in their operations.

As part of fundamental tax reform, some have suggested eliminating the deductibility of interest expense. Under such a proposal, businesses would no longer be able to deduct the interest they’ve paid on a business loan from the business’ gross income for tax purposes.

The PEGCC believes that reforming the tax code in this manner would have grave consequences for virtually every business in America, negatively impact U.S. capital markets and significantly weaken the U.S. economy.

Below are some important points to consider on this issue:

  • The tax code is neutral with respect to debt.  Every dollar of interest deducted from the borrower’s income is a dollar included in the creditor’s income.
  • Businesses issue debt for important economic reasons.  Most companies fund their operations with a mix of debt and equity. Debt provides investors with greater security than equity because it provides payment seniority and is often collateralized by physical or intangible assets (like patents).  This is especially important for attracting capital to firms with new technologies or uncertain prospects.
  • Capital structure decisions are not solely determined by tax considerations.  Empirical research has confirmed that the firms that have the most substantial free cash flow use the least amount of debt, on average.[1]  More profitable firms with greater cash flow tend to rely more on equity financing.  But smaller, younger, and riskier firms are disproportionately dependent on debt – especially bank loans – for outside capital.  A tax penalty on debt would reduce access to capital and lead to fewer high-risk businesses that, in many cases drive future innovation and creativity in America.
  • Debt financing provides important incentives.  Research has found that firms with more cash on hand invest more even, if there are no profitable investment opportunities.  Greater reliance on debt, by comparison, introduces more disciplined investment and cash management policies by removing the ability to make imprudent investments, such as the wasteful spending many corporations engaged in during the 1980s and 1990s to build sprawling, five star corporate headquarters, purchase fleets of corporate jets, and fund other management indulgences unrelated to creating shareholder value.

[1] See Graham http://faculty.fuqua.duke.edu/~jgraham/website/JACFHowBig.PDF

 

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