Should Interest Expenses Be Tax Deductible?

Abstract

This paper analyzes how shareholder wealth, firm characteristics, and public finance would be impacted if tax deductibility of interest expenses were eliminated. We find that shareholder value would decrease by 3.5%. Under the new regime, firms would be smaller and less levered, would have less productive capital, and would feature lower default probabilities. The effects on aggregate output and employment would be negative. However, the government’s revenues from corporate income tax would increase by 3% in the long-run and could be used to partially offset the negative side effects of the reform. The current period of historically low corporate bond yields is probably the best time to change the treatment of interest expenses.

Keywords: Corporate income tax, Tax deductibility, Interest expenses

JEL Classification: C68, G32, G38, H25, H32