How to Live with a Tax Code with Which You Disagree: Doctrine, Optimal Tax, Common Sense, and the Debt-Equity Distinction

Abstract

The current financial crisis and recession demonstrate the overwhelming social cost of high leverage. While many factors contributed to the development of the crisis, one factor is frequently overlooked — the tax incentive for excessive debt financing. This article explains how the debt-equity distinction in the tax code provides corporations with incentives to rely on highly leveraged finance structures. It then asserts that even though there is little justification for the tax code to favor debt over equity investment, this bias is deeply rooted and hard to overcome. Given the political difficulty in eliminating the distinction, policy makers and academics should develop a debt-equity distinction with lower social costs. However, both doctrine and academic literature fail to address this problem because the current legal discourse responds to rules that were developed in the first half of the twentieth century. In those days, the corporate tax was primarily imposed on private and closely held corporations, there was a huge difference between individual and corporate tax rates, financial engineering was limited, and the vast majority of investors and corporations were United States tax residents. None of these conditions applies today, and, as a result, the tax rules distinguishing debt from equity unnecessarily increase the social costs of compliance, and, more importantly, the costs of financial distress. Remarkably, the current rules are ineffective even in preventing tax revenue loss because they fail to recognize the weakest link in terms of tax erosion — interest payments made to foreign investors. These payments may escape United States taxation altogether because they are deductible from the corporate tax.

This article develops a more practical and easily administrable distinction between debt and equity based on two easy-to-observe and difficult-to-manipulate characteristics — voting power and duration. This new distinction should be used to classify the holdings of domestic investors in public corporations. Further, the analysis of the debt-equity distinction triggers a broader theoretical inquiry over the principles that should guide tax policy makers in line-drawing problems. As a theoretical matter, these problems arise where there is a need to distinguish between two transactions which result in dramatically different tax consequences even though they could be economically very similar.