In an FT article, Jonathan Blake, a private equity executive, makes the argument that capital should be treated the same way as other factors of production, land and labour, and interest expenses should therefore be tax deductible. He, like Jonathan Ford here, suggest treating dividends too as an expense and making them tax deductible, thereby making the playing field level for both types of capital. This, they argue, will also make any policy change less disruptive.
I have five issues with this point of view.
For a start, the answer to doing away with a distortionary and social welfare lowering preferential treatment to something is not to make that benefit available to all others. In general, across countries, not only has the tax-base shrunk (say, in real per-capita taxable amounts), but also the rates too have come down. As the Laffer curve argument informs, this lowering is beneficial only upto a point, beyond which it becomes counter-productive. There is compelling evidence that we may be on the wrong side of the curve.
Second, a standard Econ 101 response to negative externalities is to tax them. Accordingly, similar tax and non-tax restrictions are imposed on other factors of production to limit their negative externalities. In this case, we are fighting the problem of businesses leveraging up excessively on the back of plentiful and cheap credit available. The answer to this problem therefore is to tax the negative externality creating activity, excess leveraging here.
Third, each factor of production is different and they are compensated differentially based on the roles they play and the nature of the risks assumed. It is therefore misleading to argue that a particular type of compensation or benefit (among several types) applicable to some factor(s) should be available to all others. Labour wages, for example, are largely insulated from the vagaries of the business cycles, but do not share in any upside.
Fourth, the nature of the factors of production vary widely. It is now widely known that the proportion of business income going to capital is disproportionately higher than that going to either labour or land owner. In both the latter, the benefits are fixed up-front and compensation is therefore, by nature, self-limiting. But, as the egregious example of the totemic tech companies illustrates, the share of profits accruing to the shareholders and executives dwarfs that going to labour by any yardstick of evaluation or comparison. In other words, capital corners a disproportionate share of the benefits compared to other factors of production. Therefore, the removal of the tax deductibility is, contrary to the argument of Jonathan Blake, only an attempt in the direction of reducing the preferential treatment that capital enjoys in the first place.
Finally, related to the previous point, even within that disproportionate share accruing to the capital, an equal or more disproportionate share is cornered by the equity holders. Besides, the equity holders also benefit from the lower dividend and capital gains taxes. The gains from the tax exemption accorded on interest payment, therefore accrues more to equity holders than debt holders. In other words, the interest deduction is one more subsidy to the equity holders, in whose favour the labour-capital balance is already heavily tilted.
Ananth has a good post that outlines the issues here.
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