Before the end of the year, lawmakers will address several business tax provisions in a “tax extenders” package. One such provision is the limitation on the deductibility of business net interest expense introduced in the Tax Cuts and Jobs Act (TCJA). This year, the limitation tightened as scheduled and further limited interest deductions. Although imperfect, a limit is good policy, and lawmakers should avoid increasing the ability of firms to deduct interest expense.

Section 163(j) limits the deductibility of net interest expense for businesses to 30 percent of adjusted taxable income. From 2018 to 2021, adjusted taxable income was equal to earnings before interest, taxes, depreciation, and amortization (EBITDA). Starting this year, the definition of adjusted taxable income changed to earnings before interest and taxes (EBIT). This narrower definition of income means that firms face a stricter cap on net interest expense.

Limiting business interest deductions is a reasonable policy that addresses a fundamental issue with the income tax: a bias towards debt-financed investment. Under current law, businesses can deduct the cost of debt financing (interest), but not the cost of equity-financed investment (dividends). As a result, the income tax encourages businesses to borrow instead of using retained earnings or issuing new shares.

There is nothing fundamentally problematic with debt-financed investment. However, high levels of leverage can increase macroeconomic instability because, unlike equity, debt requires repayment regardless of a business’s performance. When the economy goes into recession and business revenues fall, firms with higher debt loads are less likely to pay their lenders and are at a higher risk of bankruptcy.

The deduction for interest expense also creates a hole in the US tax base. Ideally, an interest deduction for a borrower should be matched with an interest income inclusion for a lender. If both face the same marginal tax rate, there is no net loss or gain in tax revenue for the government. This does not always happen in practice. Companies often borrow money from tax-exempt entities or individuals in the United States or other companies in low- or no-tax jurisdictions. As a result, a large portion of interest expense results in a net loss in revenue for the US Treasury.

Some argue that limiting business interest deductions would harm growth by raising the tax burden on investment. While true, the impact on the overall tax burden on new investment would be minor. If lawmakers are concerned with growth, they should instead focus on the expiration of research and development expensing and the phase-out of 100 percent bonus depreciation, which have a much larger impact on investment incentives.

Others have argued that a limitation based on EBIT is flawed because it can result in an increased tax burden on new investments even if not financed with debt. While this is possible, it should not be an excuse to increase the overall ability of firms to deduct interest. Lawmakers could instead maintain a limitation based on EBITDA but lower the cap from 30 percent to a ratio that is revenue neutral with 30 percent of EBIT. A limit based on 20 percent of EBITDA, for example, would not be unprecedented. Japan recently enacted such a cap.

By limiting business interest deductions and expanding expensing, the TCJA moved the corporate income tax closer to what is called a “cash flow” tax. Under such a tax, businesses are not penalized for new investments, and all assets are treated the same regardless of how they are financed. Instead of increasing tax subsidies for borrowing, lawmakers should continue the pro-growth reforms started in the TCJA.

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