Ending the debt bias

Critics of the new Trump admin are scared the 'king of debt' is about to push the US into a debt-fuelled binge. But truth be told, the country is already far too fond of the stuff. Thankfully, it looks like Republicans are already wise to the problem.

Trump is currently negotiating with House GOP leader Paul Ryan over the shape that corporation tax reform will take. But, one area where both their plans are on the same page, is the debt-equity bias.

Under the status quo (in both the UK and US), debt is treated much more favourably by the tax system than equity. If you choose to finance a new project through borrowing then you can deduct interest repayments as cost to lower your tax bill. But if you instead wanted to fund a project through equity, that is through selling a stake in your company, then you can't deduct your dividend payouts as a cost. As a result, it's much cheaper to finance a new project through debt than equity.

This encourages projects to get funded through debt when they would otherwise be funded through equity.

This is not merely a cosmetic difference. As Chari and Kehoe point out, summarised well here by John Cochrane, equity has an automatic resolution procedure built in: owners’ shares go to zero. You don’t hear calls for governments to step in when share prices fall.

By contrast debt, which has fixed payments, not ones which vary depending on economic outcomes, tends to attract bailouts: ‘well-meaning governments lack commitment’ and step in to help pay them off when they become unpayable. They introduce a distortion by being unwilling to see creditors lose out or debtors go bankrupt. This is one reason why people worry about high debt funding in a way they don’t worry about high equity funding.

Then there's the Mortgage Interest Rate deduction. That allows US taxpayers to lower their tax bill by deducting the amount they spend on mortgage interest. As a result, there's a big over investment in owner-occupied housing.

The system is biased in favour of debt. But both GOP plans on the table will go some way to fixing that. Both plans allow for immediate expensing of capital investment, although Trump's still allows for some interest deductibility while the House plan gets rid of it entirely.

According to the non-partisan Tax Policy Centre (think of it as the US equivalent of the IFS) both plans bring the corporate tax treatment of debt and equity back into line.


They even tax debt slightly more, perhaps going some of the way to deal with Cochrane's point about the implicit bailout subsidy. I'm not sure the extra ~1% would be enough for Cochrane's purposes but it's start.

Both plans also do a little (but too little) to deal with mortgage interest deduction too. Trump's plan caps all deductions at $100k, which wouldn't affect most Americans, but very rich Americans taking out mortgages on absurdly expensive properties will take a hit. The House GOP plan instead raises the standard deduction substantially, that's the amount that taxpayers can claim if they don't make itemised deductions like the Mortgage Interest deduction.

However, if you are able to claim more on mortgage interest than you would from the simple standard deduction – i.e. if you pay more than $12,000 a year in mortgage interest – you should still deduct that. So the deduction remains solely as a handout to the very well-off. Thankfully, Britain's own mortgage interest tax relief was phased out in the early 2000s.

Some, particularly on the left, are concerned that Treasury Secretary Steven Mnuchin's call to 'strip back parts of Dodd-Frank that prevent banks from lending' will lead to the sort reckless lending that lead to the financial crisis.

I'm less worried, in part because I'm persuaded by Jeffrey Friedman's argument that misguided regulations in part caused some of the worst practices to happen.

But I'm also less worried because I think there is a strong prospect that other Republican reforms may make the US financial system substantially more stable.

Both Trump's and the House GOP's plans will lessen the tax system's bias towards debt. Britain needs to do the same. There are straightforward measures in both plans that Britain could implement. They would boost GDP and make future bailouts much less likely.