The Senate Tax Reform Bankruptcy-Triggering Time Bomb

Posted: Dec 07, 2017 8:48 AM
The Senate Tax Reform Bankruptcy-Triggering Time Bomb

There's a serious problem with the corporate side of the tax reform proposal. First, let's talk about the way things work before the change. In general companies get to 'deduct' expenses in the conduct of business. When you pay your workers, you subtract that from your revenues on your way to calculating profit. Our main corporation tax is called Corporate Net Income Tax because it taxes income, not revenues. Income is what's left of revenues once you've accounted for all the costs.

When companies borrow money to buy a piece of equipment or to build a factory, generally they do it on credit. They borrow money from a bank, or directly from markets in the form of bonds, then they use that money to operate their business. But banks don't loan money for free -- they charge rent on the money, which is called 'interest'. If the money is spent on legitimate business expenses, then the interest which is paid to borrow that money. It's a cost of doing business which means any reasonable definition of profit or net income should not include it. And with a few exceptions the tax code currently does.

But somewhere in the rush to get tax reform done, the deductibility interest is getting cut back drastically. As with many other issues, the Senate version is worse than the House version. Both significantly curtail the deduction by putting a cap on it, but the Senate cap is much lower than the House cap. The Senate cap particularly punishes companies with a lot of depreciation and amortization expenses, which is tax-ese for the expenses pertaining to long-term equipment and long-term intellectual property. Depreciation tends to be the larger item, which means that this change in the code will be particularly hard on companies with a lot of heavy long term assets: miners, manufacturers, et cetera.

It's also going to be hard on growing companies which have financed that growth through debt. There is a reasonable debate about whether we should change the tax code to discourage companies from taking on debt in the future, but there doesn't really seem to be a reasonable debate about whether to severely punish companies now by changing the rules under which they accumulated their debt. The law encouraged borrowing as a growth tool and then the business made those decisions -- sound decision under the law at the time. To change the game on them now is to pull the rug out from under these businesses. Debt is frequently a serious burden for businesses, especially for capital intensive ones. Owners take big risks to expand operations, and they rightly bear the risk of that decision. But changing the tax status of this debt after the fact can turn a bearable burden into a business-crushing burden. And the next time we hit one of our cyclical deflationary recessions (which we will), those companies will be hit hard and many will be unable to pay both the debt service and the added taxes, and we will see an avalanche of corporate bankruptcies, which will hurt both the employees of those companies and the employees of the creditors. And it will be Republicans’ fault. When the houses put their best heads together to iron out the difficulties, they should at least harmonize the deduction upwards: they should use the House's more business-friendly (or is it less business un-friendly) approach. If the GOP wants to make the decision whether a company raises capital by issuing bonds (debt) and paying interest, or issuing stock (equity) and paying dividends, then the right approach is not to raise taxes on the debt option, but rather to lower taxes on the equity version. The GOP is supposed to be the tax-cutting party, right?