As a follow-up to my earlier post on the revenue implications of the Obama administration’s corporate tax reform framework, there is a major escape valve for turning at-best revenue-neutral tax reform into appropriately revenue-positive reform. In its framework, the administration singled out the deductibility of interest payments as one of the key imbalances in the tax code, along with distortions across industries’ effective tax rates, distortions among businesses’ organization (i.e., pass-through entities versus C-corporations), and distortions favoring offshoring. (The Center on Budget and Policy Priorities’ Chuck Marr has a good overview of this part of the framework.) These are all key areas for improvement in the tax code, but the deductibility of interest payments also has serious potential for raising revenue and curbing systemic financial risk.

This feature of the tax code distorts corporate financing decisions by pushing the effective tax rate on debt-financed investment well below the effective tax rate on equity-financed investment. The Treasury Department estimates that the effective marginal tax rate on debt-financed corporate business investment is -4.4 percent (a subsidy), versus a 36.8 percent for equity-financed investment – quite the tax wedge. Profits from equity-financed investment will be taxed at the effective corporate rate (26 percent on average), and after-tax profits will be taxed when disbursed to shareholders as dividends or realized as capital gains, both at the 15 percent rate. Conversely, Treasury notes that “profits from the same investment funded by debt will only be taxed to the extent they exceed the associated interest payments” and the interaction with the accelerated depreciation deduction results in a big tax subsidy. This is a huge boon to industries reliant on debt, notably the highly leveraged financial sector, although the value of the so-called “debt tax shield” weighs against the costs of financial distress associated with indebtedness.

We previously proposed limiting the deductibility of interest payments in our budget blueprint Investing in America’s Economy, with emphasis on reining in financial sector leverage. (This progressive budget report was a collaboration of Demos, EPI, and The Century Foundation.) The tax code should not subsidize systemic financial risk in the form of high leverage ratios (in balance-sheet terms, the ratio of assets to net worth). Emerging from the worst financial crisis since the Great Depression, curbing the debt tax shield should be a no-brainer: Lehman Brothers was leveraged 30-to-1 when it collapsed in Sept. 2008. This concern should have been addressed after hedge fund Long-Term Capital Management went bust in Sept. 1998 with a balance-sheet leverage ratio over 50-to-1. (LTCM was deemed systemically important, and the New York Fed organized a bailout by private investors.)

The administration proposed “reducing the bias toward debt financing,” which, while lacking specificity, could be a major revenue source. The deductibility of interest payments is not considered a “tax expenditure” (it’s not a deviation from the tax code, it is the tax code) so this isn’t included in the Joint Committee on Taxation’s estimate that revenue-neutral tax reform could only lower the corporate rate to 28 percent rate. (As I noted, the administration wants this 28 percent rate and permanent tax breaks for manufacturing, drawing into question whether these tax changes will result in reform or a tax cut.) Broadening the tax base into interest payments could help lower the corporate rate to the targeted 28 percent, fund the proposed continuation of the research and experimentation credit, level the playing field across financing decisions, and contribute to deficit reduction. There is a huge sum of money at stake here.

The Federal Reserve’s Flow of Funds data show $11.5 trillion in outstanding non-financial business debt and $13.7 trillion in outstanding domestic financial-sector debt as of the third quarter of 2011. It doesn’t take a leap of the imagination to conclude that there is real revenue potential in curbing the tax code’s debt-financing preference. Doing so could ensure that tax reform helps restore revenue adequacy while mitigating the subsidization of systemic financial risk.