photo by Flickr user Andria
The biggest challenge when designing an income tax system is deceptively simple: how to define income.
If every transaction involved only cash, income would not be complicated. Measuring the amount would be straightforward and you could time the transaction precisely. Yet in the real world, transactions often involve assets such as buildings or machines, which makes such calculations more complex. After all, the Internal Revenue Service wants you to recognize the expense over the asset’s useful life – but it also wants you to pay tax due today.
Enter the interest deduction. Under current federal tax rules, business interest is deductible as an ordinary expense, as long as the loan is used to purchase assets for the business or pay the business’ expenses.
Say Mike owns an independent ice cream shop and wants to invest in a top-of-the-line soft-serve machine that costs around $10,000. Ignoring any special rules that might apply, we’ll further say the IRS expects the machine to have a useful life of 10 years. That means Mike can only deduct $1,000 of value in the year he buys the machine, because he will capitalize the rest over the machine’s useful life. But the other $9,000 is still subject to tax that year. Unfortunately for Mike, you can’t pay the IRS in soft-serve machine parts.
Existing interest deduction rules mean that if Mike borrows $9,000 and only pays $1,000 out of pocket, he can use the cash he would have otherwise spent on the machine to pay the tax he owes. He’ll eventually pay back the $9,000 plus interest, and the tax law recognizes that this interest is a business expense.
In real life, this deduction doesn’t just affect the Mikes of the world. It underpins much of U.S. commerce, from major corporate acquisitions to farming. Which means that if congressional Republicans succeed in scrapping the interest deduction, the change will have far-reaching consequences.
The existing proposal would, effectively, change accounting reality to more closely match the reality of cash flow. The new system would not only get rid of the deduction for interest; it would also let Mike treat the entire $10,000 machine as an expense in the year he buys it, recognizing the fact that once he pays for it, that money is gone. In fact, small business owners like Mike can already do this for certain types of equipment up to an annual limit ($500,000 in 2017) using the section 179 deduction.
If the Republican plan makes it into law, businesses could still use debt to pay their expenses. They simply wouldn’t receive any tax benefit for using debt as opposed to another method of raising capital, such as sales of stock. Rep. Kevin Brady, R-Texas, who wrote the plan, told The Wall Street Journal, “What we’re proposing is to take the tax preference from the source of funds – borrowing – and take that preference to the use of funds – business investment and buildings, equipment, software, technology.”
Whether the plan will make it into law is far from certain. Debt-heavy industries such as agriculture and real estate have already criticized the plan, and Treasury Secretary Steven Mnuchin said in a recent interview that keeping the interest deduction is “our preference,” though eliminating it was not entirely out of the question. Yet allowing full and immediate expensing without removing the interest deduction would effectively offer businesses double-dip tax benefits.
Until we see the final bill that Congress sends to President Trump, we will not have a comprehensive picture of how tax reforms might affect American businesses. But it strikes me that, as long as businesses can immediately write off expenses, taking away the deduction for interest is a fair exchange. Its main effect will be to remove the built-in preference for borrowing that exists today, which will hurt certain businesses more than others, but will not prove an overall negative. Legislators may also end up with a compromise position, in which capital expenses and interest are each deductible up to certain limits.
The Journal also reported that any change will likely only apply to new loans. This is probably one reason that financial markets have not measurably reacted to the potential loss of the interest deduction so far. And while a change this major will certainly require adjustment, it is neither harsh nor illogical. After all, if the IRS expects businesses to come up with the cash to pay in the year a transaction occurs, it is not outlandish to accelerate expensing to that year.
Given his real estate background, President Trump may be reluctant to axe the interest deduction. But when paired with accelerated expensing, as in the Republicans’ proposal, it is a fair suggestion for how to move forward.