- Overall, the U.S. federal income tax system is intended to include deductions for interest paid and taxation on interest received. However, a substantial portion of interest received is untaxed.
- The combination of deductions for interest paid and untaxed interest income results in a substantial gap in the income tax, amounting to as much as 33 percent of all corporate debt.
- Interest deductibility is also a key feature of many profit-shifting arrangements, where multinational corporations borrow in order to reduce U.S. taxable income against the high U.S. corporate income tax rate.
- The net subsidy for leverage created by interest deductibility may contribute to financial crises because unexpected defaults on debts often lead to a macroeconomic cascade of troubled financial assets.
- Several reforms have sought to limit interest deductibility in recent years, and these reforms should be taken seriously.
- Tax provisions should be evaluated on the basis of opportunity cost; limiting interest deductibility is a better idea to raise revenue than many other options.
One major unresolved question in tax policy is the appropriate treatment for interest payments. Interest payments exist in a sort of in-between area for tax policy: interest involves money changing hands, but it creates no net increase in national income. Some tax systems attempt to track interest payments as they change hands and adjust tax burdens based on those interest payments. Other tax systems take a shortcut and acknowledge that on net, every interest payment has matching interest received elsewhere, and therefore, one can simplify the code by ignoring interest entirely.
There are principled arguments for both approaches. For example, the argument for deducting interest paid and taxing interest received goes something like this: When money changes hands in the form of interest, an income tax would ideally want to follow the money until it reaches its final owner. Interest is income, after all, as most individuals understand it, and it makes sense to include all sources of income in one’s income tax liability. This is, at least in theory, the design for the U.S. income tax.
For an alternative tax system, one could note that all interest payments and interest receipts cancel out, and therefore exclude both interest receipts and interest payments. This approach has its virtues as well, especially its relative simplicity. This is the design for a number of approaches to business taxation worldwide.
These two approaches are not the only ones possible, but they are the two systems in which tax revenue is invariant to the amount of borrowing in the economy. Most tax systems, at least by their original intent, choose one of these two options for interest treatment. However, it is worth mentioning two other potential systems. A system that taxed interest received but did not allow an equal deduction for interest paid would be a net tax on leverage. A system that allowed a deduction for interest paid but did not have an equal tax on interest received would be a net subsidy for leverage.
While the U.S. income tax system is intended to match deductions for interest paid with taxes on interest received, in practice it is a convoluted mix of the systems described above. As a result, it hemorrhages tax revenue, distorts business decisions, and potentially even contributes to financial crises.
Under the current U.S. income tax system, most interest paid is deductible, and interest received is usually taxable. The ideal, one might imagine, is to tally up everyone’s income, with interest receipts counting as positive income and interest payments to others counting as negative income. Once everyone’s income is determined, that income is subject to the income tax at progressive rates. In practice, though, the U.S. income tax system doesn’t always follow this ideal with respect to interest.
For example, interest paid is only sometimes deductible. While businesses can almost always deduct interest, individual income tax filers are often not able to do so. For example, they can deduct mortgage interest, but this option has value only if the standard deduction isn’t a superior alternative. Even when they do choose to itemize, the cost of the foregone standard deduction may reduce the value of the mortgage interest deduction to the taxpayer. Furthermore, many consumer loans, such as car loans or credit card loans, are not deductible.
Interest received is also not always taxable. While individuals and institutions both typically pay taxes on interest in many circumstances, there are several exceptions. Interest from municipal bonds is tax-free, making them a popular investment choice for wealthy individuals. Many private institutions, such as university endowments, are exempt from income taxes, allowing them to receive interest tax-free. Individuals who take advantage of defined-benefit pensions, 401(k) plans, or Individual Retirement Accounts, are also able to lend without paying taxes immediately on interest receipts.
Overall, the U.S. federal income tax adheres to no consistent principle on interest payments.
Source: Tax Foundation