Treasury Finds TCJA Interest Limitations Had Small Impact on Corporate Activity

A new working paper published by U.S. Treasury economists found that the interest limitations implemented under the 2017 TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
Cuts and Jobs Act (TCJA) had limited impacts on investment and debt levels. While the result suggests that limiting interest deductibility further could raise revenue without substantially hurting investment, more research is needed, given how the macroeconomic environment today is different than the period covered in the study.

Many corporate tax codes across the world allow firms to deduct their interest expenses from their taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.
while taxing any interest income they earn. This deductibility reduces the costs of debt financing for firms, but as result, incentivizes firms to prefer borrowing over equity financing and potentially increases macroeconomic risk.

To help shift the U.S. corporate tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.
closer to a cash flow one and offset the revenue costs of other tax cuts, policymakers implemented an interest limitation under the TCJA. Until 2022, the deduction for net interest expense was limited to 30 percent of earnings before interest, taxes, depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment.
, and amortization (EBITDA). For the years following, the restriction has been tighter because the base switched to earnings before interest and taxes (EBIT), a smaller measure.

The interest limitation only applies to firms earning more than $25 million in average receipts over the previous three years. The authors of the new working paper exploited this difference in the law’s application to isolate the impacts of the interest limitation on indebted large firms compared to indebted small firms, looking specifically at the first two years after TCJA passed.

The authors found that the interest limitation did not have a statistically significant effect on investment or cash-financing. High-interest firms, who on average had $20 million in interest disallowed, were however more likely to issue equity, although the effect was small. Specifically, for each dollar of assets, equity issuance increased by about roughly a penny.

One reason the authors do not find large effects on investment is that large indebted firms do not appear to prefer debt as their marginal financing source; they prefer to finance new investment with cash. Additionally, the authors note that firms might also face large fixed costs for shifting their borrowing behavior, as debt levels did not change following the interest limitation.

While the results indicate that further limitations would raise revenue without imposing much economic pain, we should consider that the study only examined highly indebted firms in a low interest rate environment. Today’s environment features higher rates; the current federal funds rate is more than double the rate in the period studied in the paper. The interest limitation is now tighter, too, under EBIT. Combined, highly indebted firms are much more likely to feel the sting from an interest limitation. And smaller indebted firms might also have less access to capital when faced with higher interest rates.

Limiting interest deductibility continues to be a worthwhile policy goal, but given the current climate, policymakers should opt to pair any further limitations with other pro-growth policies such as full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs.
to ensure firms’ incentives to invest are preserved.

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