Is it wise to allow a tax deduction on interest?

The Economist thinks it's not. It calls tax deduction allowed to interest payments "the great distortion". It estimates tax revenue forgone on this at 3% of GDP in Euope and 5% of GDP in the US. But this is not the only damage it causes, the journal says. The bigger problem is that it gets individuals and companies to build up leverage, and this renders economies fragile- as happened in the sub-prime crisis.

What do we make of these arguments? Well, the Economist's arguments haven't really been couched in precise terms. There are two components to the question. The first is: should interest be tax deductible? The answer is, yes, for the simple reason that interest is an expense- and there's no reason why it should be treated differently from other expenses. Besides, as economist Tyler Cowen points out, if companies did not have incentives to take on debt, they would use cash for all expenditure. They wouldn't have cash hoards as a result and would go bankrupt more easily. Thirdly, tax deduction of interest expense and tax paid on interest earned are two sides of the same coin- what you save by tax deduction, you pay as tax on your savings, subject to inefficiencies in the system.

It's the second part of the question that is more important: should debt be taxed differently from equity? The higher tax shield on debt gets companies to use more debt than they would otherwise. It is this that renders them more vulnerable. The Modigliani-Miller proposition 1 says that, in the absence of taxes, it doesn't matter whether a company uses debt or equity. Once you introduce differential tax rates for debt and equity (with debt treated getting a higher tax shield), debt is advantaged over equity. This is where the distortion arises.

When we look at the real world, however, we finds lots of 100% equity companies but no 100% debt companies. The best performing companies, such as Apple and Microsoft or, for that matter, Infosys in India, don't bother to avail of the tax shield on debt. Why? Because they are run so efficiently - in terms of their market cap- that they couldn't be bothered with the tiny addition to market cap that debt would confer.

For companies that aren't run as well, however, the addition to market cap provided by the debt tax shield does matter. If we made the companies fully reliant on equity, there would be a cost to shareholders. Either shareholders must accept a lower return- which would limit companies' access to equity- or consumers must pay a higher price. The economy suffers as a result.

The really big distortion is in banking.There, leverage is 33:1 or even higher because of the implicit safety net given to banking. But the answer to this problem is not eliminating the tax shield on debt but finding ways to limit the safe net for banks!