Why is interest tax-deductible?
Hi,
Every time I start reviewing for my interviews I stumble upon the same question but can't for my life find the answer.
Question on Interest Expenses
Why exactly are interest expenses tax-deductible? What exactly is the reason for tax authorities to allow this? To promote the efficient use of debt? I have a feeling that there is some basic underlying idea I'm missing but I can't put my finger on it.
Answer
Interest expenses are tax deductible because it is an expense. Someone else is recognizing income when you pay interest expenses, so you get to recognize it as an expense. Specifically, Sec. 163 of the IRS Code authorizes it. The policy behind it is that interest is the cost of doing business/generating income. The point of the tax code is to tax "income", which means taxing them on net gains as opposed to gross.
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Coz that's how itz always been
because if interest was not tax deductible it'd just be rephrased as something that is, like sharia compliant debts....
Sec. 163 of the I.R.C. authorizes such. The policy behind it is that interest is the cost of doing business/generating income. The point of the tax code is to tax "income", which means taxing them on net gains as opposed to gross.
Because it's an expense and people would do crazy stuff like capital leases to avoid it. The bottom line is that someone else is recognizing income when you pay interest, so you should be allowed to recognize an expense.
This does not hold true for consumer debt, car loans, and other debts- that was changed with the Tax Reform Act of 1986.
What if interest payments were not tax deductible? (Originally Posted: 05/25/2015)
Hi!
Recently there was an article in The Economist arguing that debt shouldn't be artificially subsidized by tax deductibility of interest payments (both for corp and mortgages). They also suggested that this can be changed gradually and the total tax burden could be kept constant by decreasing the overall tax rate on corporate profits.
I'd say that pretty strong argument was when they compared the .com bubble vs credit crisis. The nominal losses were higher during .net crash but it didn't result in so much damage as the credit crisis.
I was thinking what would be the consequences of that if we assume every country in the world would change this at the same time.
One thing (which they didn't mention in the original article) would be structured credit bonds where an SPV receives payments from loan pools and pays coupon and principal on the bonds it issued. If that would be taxed, the whole thing makes no sense anymore.
What do you think about this?
I'm a bit clueless on these macro issues - but my impression is that a significant number of US corporations pay little to no US corporate taxes. This means that the elimination of a tax shield will result only in a significantly reduction in profits and liquidity. Private equity firms would also really hate this, and it'll likely reduce M&A activity as well as capital expansion projects that are principally financed by debt.
Note that the elimination of a tax shield significantly increases the cost of debt, which means that companies will likely increase the required rate of return on capital projects. Decreased investment activity is not good for the US economy.
Interested in what others think, however. I could be totally off-base.
Housing prices would likely collapse
@7xEBITDA" you hit the nail on the head. Also I'll add that the free flow of credit is vital for business success and removing the tax shield will result in smaller and mid-sized companies failing or experiencing a stagnation in growth.
This hurts not only Wall Street but Main Street as well and if the Cost of Debt soars (which it will in this scenario) it has a negative impact on everyone save for those that deal strictly in cash.
I can see some significant consequences for corporations, but not so sure about the nortage side.
Consumers really do not benefit from the mortgage interest deduction as much as the general public thinks. A married couple automatically gets a standard deduction of $12,400, so unless you pay more than $12,400 in mortgage interest and other itemized deductions per year, you aren't deducting your interest at all and you get the same tax benefit as the renter down the street.
For this reason, many homeowners are not actually deducting their mortgage interest at all. And even if you do pay say $15,000 in a given year for mortgage interest, your tax benefit from owning the house would only be about $650 ($2,600 above the standard deduction of $12,400 X 25% tax rate). I doubt that a loss of $50 a month for just a portion of homeowners will drive any real economic changes.
Why are interrest payments tax deductible? Why is the Government effectively paying part of the interrest payments? (Originally Posted: 12/30/2012)
Hi,
I understand the impact of the Tax shield. But I was wondering why the Government is effectively paying part of the interrest payments.
What are they trying to achieve with this?
Subsidize Banks :) ?
Thanks
Encourages people and companies to invest which would ideally lead to more home ownership (in the case of mortgages) and more capital investment (in the case of companies). Both create more output in the economy overall which also leads to further tax revenue itself.
Encourages debt-fuelled spending which is basically what Western economies run on nowadays.
Because more leverage = more better
To make cost of debt cheaper, which will encourage more capital spending (usually for expansion or development but sometimes CEO's pay) which will boost economy through increased GDP output, employment, competitive advantage (possibly lead to trade surplus) etc. I think the whole idea is built on trickle-down effect, which somewhat works in the western world but not so much in Asia.
TLDR: It's not just about the money. its social engineering.
If you buy a home, you have to put stuff in it. Whatever the gov't loses via home mortgage interest deductions off individual tax returns they make up in sales and use taxes and income taxes levied on the businesses that sold you those products.
Making it easier to buy a home also makes it easier to start a family. More kids = higher population. Higher population = more tax revenues, larger potential military, larger work force and more people who may eventually buy homes and continue the cycle. That's why everyone in the media is flipping shit over the inevitable end of the boomer generation and rise in the average age of a newlywed. We need kids. Military aside, these little bastards need a new wardrobe every year or two as they age and cost the average family hundreds of thousands of dollars to raise. Kids are expensive, in many cases both parents need to work to support their family. Who raises the kids? Gov't sponsored public education and free network television.
Every mortgage holder is now in debt; more debt then they will ever be in ever in their lives. Pretty nifty way to keep people in line. If you break the law and get sent to jail, you lose your job and proceed to default on your mortgage payments and consequently lose your home and any principal that you had in it. Now your credit score is shot and getting a job after jail time is awfully difficult. In order to raise your credit score you need a job and in order to get a job you need a credit score and / or a clean record. Ain't that a bitch. Seeing as how our local police forces aren't quite at the "Minority Report" level we use heavy penalties as a crime deterrent since prevention is damn near impossible.
Once you own property it becomes part of your taxable estate. Accumulate enough coin over your lifetime and the death tax hurts. If you inherit a home from your parents and can't afford to keep it you sell it. Now you're paying tax on the sale of gifted property. Your basis in the property gets stepped up, which helps minimize the tax effect on the kids, but pushes up the value of your estate. Estate tax rates are higher than regular income tax rates.
No such thing as a free lunch
To spur investment.
/thread
It's a cost of doing business. Businesses are taxed on profits.
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