In 2017, corporations had a lower cash to debt ratio than ever before. However, the Tax Cut and Jobs Act passed in December of 2017 reduced, but didn’t eliminate, the tax incentives for firms to take on debt. Therefore, PWBM projects that corporate debt will be seven to nine percent lower going forward.
The Net Interest Deduction
U.S. tax law provides businesses with an incentive to use debt rather than equity financing. Businesses may deduct net interest payments from their taxable income, thereby lowering their effective tax rate. However, payments to shareholders (dividends and capital gains) may not be deducted from taxable income.
In 2017, before the TCJA, U.S. businesses could, in general, deduct the full value of their interest costs from their taxable income. Therefore, the value of the tax benefit a business receives depends primarily on the tax rate it faces because interest payments don’t affect tax liability directly. In addition, businesses must have positive taxable income in order to immediately realize the benefit. Businesses with losses already face zero tax and cannot reduce their liability any further. However, these businesses can carry unused interest deductions forward as net operating losses and use them in the next year they have positive taxable income.
Major TCJA Provisions Impacting Corporate Debt
The TCJA substantially reduces the tax advantages of debt financing. Most directly, the Act limited the amount of interest a business can deduct to its net interest income and 30 percent of its adjusted taxable income.1 Businesses with interest costs greater than this limit must include the excess in their taxable income for that year.2
The TCJA also lowered the corporate income tax rate from 35 percent to 21 percent. It also introduced a new 20 percent deduction for income from pass-through entities, which effectively lowers the tax rate faced by those businesses. At a lower tax rate, the tax savings from reducing taxable income are smaller, making interest deductions less valuable to corporations and pass-through entities.
In addition, many of the Act’s other provisions indirectly affect the value of interest deductions because they change the likelihood that a business will have taxable income against which the deduction can be claimed. For example, the Act temporarily allows businesses to immediately deduct the full cost of some capital expenditures. Businesses that do so will have less taxable income before accounting for interest and therefore less opportunity to benefit from interest deductions.
While the limitation on interest deductibility is the provision most straightforwardly related to the tax benefits of debt, its impact is relatively small compared with the changes to tax rates. In our analysis of the TCJA, we estimated that about 10 percent of business interest expense (in present value terms) would be disallowed as a deduction over the next two decades. The change in the corporate tax rate, meanwhile, reduces the value of interest deductions by 40 percent (the ratio of the 14 percentage point reduction to the initial rate of 35 percent).
Corporate Debt in PWBM’s Dynamic OLG Model
Businesses finance themselves via debt issuance or equity issuance. In a world without financial markets and policy distortions, the choice of financing is neutral, as shown by Miller and Modigliani (1958).3 If government subsidizes debt through interest deductibility, companies naturally choose to finance themselves through debt.
With debt comes the possibility of default. Creditors also naturally demand a higher interest rate from highly leveraged companies, thereby reducing the company’s net benefit of debt. Optimally, firms issue just enough debt so that the marginal cost of another dollar of debt is offset by the marginal tax benefit.4 The marginal tax benefit of corporate debt is a multiplication of the business tax rate, the debt interest rate, and the deductibility of interest. The methodology applied by PWBM’s Dynamic OLG is described in a detailed whitepaper.
Lower Corporate Debt Under the TCJA
We project that corporate debt will be lower under the TCJA than under previous tax law in both the short and the long run. Figure 1 shows that, in 2022, the corporate ratio of debt to capital will be seven percentage points lower than under 2017 tax policy. By 2042, corporate leverage will be nine percentage points lower than under previous policy.
| Year | Corporate Leverage Ratio (percentage point change) |
|---|---|
| 2022 | -7 |
| 2027 | -9 |
| 2032 | -9 |
| 2037 | -9 |
| 2042 | -9 |
Note: Consistent with our previous dynamic analysis and the empirical evidence, the projections above assume that the U.S. economy is 40 percent open and 60 percent closed. Specifically, 40 percent of new government debt is purchased by foreigners.
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The inclusion of interest income means that the limitation applies only to net interest expense. Adjusted taxable income is taxable income calculated without regard to net operating losses and certain other deductions. ↩
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However, any interest expense denied as a deduction may be carried forward to subsequent years. ↩
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Modigliani, Franco, and Merton H. Miller. “The Cost of Capital, Corporation Finance and the Theory of Investment.” The American Economic Review, vol. 48, no. 3, 1958, pp. 261–297. JSTOR, JSTOR, www.jstor.org/stable/1809766. ↩
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Debt may offer benefits other than tax--for instance, monitoring of the firm by creditors--that we don’t account for. ↩