Congress’s two tax-writing committees convened a rare joint hearing Wednesday to consider whether the Tax Code is providing too many incentives for accumulating debt as opposed to equity.

Both the Senate Finance Committee and the House Ways and Means Committee heard testimony and reviewed the findings of two new reports from the Joint Committee on Taxation on the tax treatment of business debt and the tax treatment of household debt. It was the first time the two committees have held a joint tax hearing since 1940, when the subject was war taxes.

During the hearing, the two committees looked at ways to improve the Tax Code to encourage job creation and grow the economy, while ensuring that the different tax treatment of debt and equity does not encourage households and businesses to take on too much debt. 

The hearing, which is part of an ongoing series on tax reform held by the Senate Finance Committee, occurred against the backdrop of fraught negotiations between congressional leaders and the White House on raising the debt ceiling before an August 2 deadline threatens to bring a historic government default

“As we work to reform the Tax Code to create jobs and bolster our economy, we need to evaluate the role corporate and household debt plays in economic stability and growth,” said Senate Finance Committee Chairman Max Baucus, D-Mont. “The Tax Code should boost widespread economic growth, but we must ensure it does not also encourage businesses and individuals to put themselves in precarious positions by taking on too much debt.”

At the hearing the lawmakers examined the impact of the Tax Code’s treatment of debt and equity on job creation, economic growth and household and business debt. Baucus sought answers about the best way for the code to treat and define debt to increase growth in the economy and ensure that it is not vulnerable to financial crises in the future. 

Sen. Orrin Hatch, R-Utah, the ranking Republican member of the Senate Finance Committee, said that tax reform should be based on the same three principles that led to the enactment of the Tax Reform Act of 1986: fairness, simplicity and economic growth. “Our tax system encourages the use of debt rather than equity in the area of corporate finance as well as household finance,” Hatch noted. “If a corporation is in need of additional funds, our tax system encourages the corporation to borrow money rather than raising funds by issuing stock. Why? Because any interest payments on the borrowing are deductible while any dividends paid on the stock are not deductible. In addition, many U.S. multinational corporations are sitting on large piles of cash, yet these corporations are borrowing money. One reason is that their cash is trapped offshore, and the corporations will be subject to a 35 percent U.S. tax on repatriating the cash back to the United States. The increased use of debt by both households and corporations makes both more vulnerable to the risks of bankruptcy and other downturns in the economy.”

Rep. Sander Levin, D-Mich., the ranking Democrat on the House Ways and Means Committee, referred to the current debate over the debt limit in his introductory remarks.

“Because of the uniquely serious challenge facing this nation—action on the debt limit—today it would be more appropriate if we were gathering to discuss this challenge,” he said. “This issue—the debt limit—is squarely within the jurisdiction of our two committees. That does not mean that the specific topic before us is unimportant. Indeed, if we are to seriously address tax reform, issues relating to debt and equity must be considered and like other significant issues, done so in depth and with open debate.”

Levin said he worried, however, that the hearing would be a waste of time if the debt ceiling is not raised. “We should hear and review carefully the testimony now to be presented to us by our distinguished, knowledgeable witnesses,” he said. “But I fear that any insights that we gain in the process will be washed away if the debt ceiling is not raised and we suffer the momentous consequences that would result from destroying the full faith and credit of our nation.”

Pamela Olson, a former Assistant Treasury Secretary for tax policy from 2002 to 2004, and currently a partner at the law firm Skadden, Arps, Slate, Meagher & Flom, noted that in its current form, the Tax Code provides an incentive for businesses to raise capital through the issuance of debt, rather than through the issuance of equity.
“The incentive arises from the interplay of two features of our tax system,” she said in her prepared testimony. “The first is the double-taxation of corporate income, which flows from the choice to treat corporations and their investors as separate taxable units. Corporate earnings are taxed at the corporate level, and then again at the shareholder level when the corporation distributes earnings to shareholders. The second feature is the tax deductibility of interest payments made to creditors. While interest payments are deductible by the corporation, distributions of earnings to shareholders are not.”

Incurring debt thus serves as a straightforward means of mitigating the double tax on corporate income because corporate earnings paid as interest are deducted from the corporation’s gross income and are taxed only to the recipient of the interest income, Olson added.

Victor Fleischer, an associate professor of law at the University of Colorado Law School, said in his testimony that he had spent the last 10 years researching how corporate financings and other deals are structured. “The main point I want to make today is that the debt/equity distortion, like other distortions in the Tax Code, is costly on two levels,” he said. “The first level of costs is obvious. Deals are restructured to reduce taxes, which erodes the tax base. This is the explicit cost of the distortion. The second level of costs is implicit. When a corporation restructures a deal to reduce taxes, the restructuring imposes an implicit cost on the corporations themselves: corporate managers are willing to add complexity to their capital structure, distort corporate governance, and even change investment policy and other critical business decisions as long as the tax savings are worth it. Furthermore, the debt/equity distortion imposes an additional implicit cost on the public in the form of increased firm bankruptcies, plant closings, taxpayer bailouts and the like. Finally, the distortion encourages a lot of wasteful tax planning.”

Simon Johnson, a professor of entrepreneurship at the MIT Sloan School of Management, noted that the U.S. Tax Code creates a “debt bias” that encourages borrowing by households, the nonfinancial sector, and financial firms. “Primarily because interest payments can be deducted as an expense when calculating taxes, homeowners borrow more relative to house prices, and firms finance themselves relatively more with debt and relatively less with equity,” he noted. “A high degree of leverage—more debt relative to assets—increases the upside return to equity when asset prices. But it also exacerbates the downside losses for equity when asset prices fall. This is true for firms and banks; it is also true for households—as many American families unfortunately discovered when house prices fell.”

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