Report: Reduced Interest Deduction Will Harm Economy, Leave America Uncompetitive

Submitted by IMorales on Tuesday, June 22nd, 2021, 2,00 PM

If lawmakers fail to act before the end of the year, American businesses, particularly manufacturers, across the country will face a significant tax increase. This impending tax hike will diminish the ability of businesses to deduct net interest expenses, which will harm the economy and American competitiveness, as noted in a recent report from PricewaterhouseCoopers (PwC).

Currently, businesses can deduct net interest expenses (i.e. debt) up to 30 percent of earnings before interest, tax, depreciation, and amortization (EBITDA) under IRC section 163(j). However, effective 2022, this deduction is narrowed to 30 percent of earnings before interest and tax (EBIT). 

Removing depreciation and amortization from the calculation of the deduction will reduce the value of the tax deduction, resulting in a tax hike for many capital-intensive taxpayers including manufacturing businesses. Allowing the EBIT standard to go into effect could also result in a tax increase of $140 billion on American businesses over the next decade, according to a Joint Committee on Taxation report analyzing the Tax Cuts and Jobs Act.   

PwC’s report concluded that this tax hike would result in reduced investment, reduced economic growth, lower average labor productivity and ultimately lower wages, with manufacturing and information industries bearing over half of the overall tax increase. It also found that the tax hike will leave American businesses less competitive because other countries that have earnings-based limitations use the EBITDA standard, not the EBIT standard.

First, the report analyzes what would have happened in 2019 if the EBIT-based limitation had been in effect. It finds that American businesses would have seen increased costs of borrowing and increased taxes:

  • “US public companies would have had an estimated $29.9 billion of additional excess interest expense, with companies in manufacturing, information, and mining seeing the largest increases in excess interest expense.  
  • US public companies would have paid an estimated $4.7 billion of additional incremental tax, an increase of 275.5 percent relative to the tax increase under an EBITDA-based limitation. Companies seeing the largest increases in tax relative to an EBITDA-based limitation are in information, manufacturing, and transportation and warehousing.  
  • Companies affected by the limitation would have had excess interest expense on average equal to 47.3 percent of their total interest expense. The mining sector would lose almost three-quarters of its interest deductions while the educational services and administrative and support and waste management and remediation services sectors would lose about two-thirds. Worse, low profitability companies would account for more than 60 percent of additional excess interest expense.
  • On average, taxpayers affected by the change would see close to a three-fold increase in their incremental tax liability. However, the change is much higher in some industries. For example, the average accommodations and food services industry taxpayer will see a 35x increase in their incremental tax liability.” 

 

Second, by increasing the cost of capital, this tax hike will hinder economic growth, harm American workers, and restrict business flexibility and cash flow. As the report explains:  

“The increase in the after-tax cost of capital as a result of the limitation on the deductibility of interest is likely to reduce investment. Lower capital investment reduces economic growth and average labor productivity. Lower labor productivity results in lower wages.” 

Third, the report notes that this tax increase would disproportionately hit less profitable companies. These effects are magnified during an economic downturn, as the report explains:

"Companies in cyclical industries with income subject to greater fluctuations may find the limitation restricts interest deductibility during periods of weak economic performance while during periods of normal profitability the companies can fully deduct their interest expense... The limitation increases the cost of capital, making it more expensive to undertake investment during recession times as well. An EBIT-based limitation may be susceptible to larger percentage fluctuations when revenue declines than an EBITDA-based limitation due to depreciation, depletion, and amortization deductions on current and prior year investments."

Lastly, the tax increase would make American businesses less competitive with foreign businesses. In fact, the existing EBITDA standard used in the tax code is the universal standard for earnings-based interest limitations. Of the 35 countries that have  the same interest limitation rule as the United States, all of them employ an EBITDA standard.

Narrowing the deduction by adopting the lesser EBIT standard would leave American businesses uncompetitive with countries like the United Kingdom, Germany, Japan, and France. Further, the 30 percent businesses can deduct of earnings is also the international norm and is used by 27 of the 35 countries mentioned.

Lawmakers should act to make the existing EBITDA standard permanent. Senator Roy Blunt (R-Mo.) has introduced a bill to do this, which should be supported by all members of Congress.

Allowing the tax hike on interest deductions to go into effect at the end of the year will harm the economy, make America uncompetitive, and reduce business flexibility.

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