I wanted to be sure to highlight this excellent piece by Merrill Goozner on the tax advantage enjoyed by corporate investors–he focuses on private equity firms–from their ability to deduct interest payments on their debt from their tax bill.
The business interest deduction distorts economic activity, according to a report issued last year by the Joint Committee on Taxation. It encourages companies to raise capital through debt rather than equity, since returns to stockholders – dividends – come out of after-tax profits (and then are taxed again as part of recipients’ individual tax returns). Payments to bondholders, on the other hand, is a deduction from earnings.
Check out these effective tax rates on corporate investment from a Brookings paper a few years ago—the rate on debt financing is negative! No wonder we’re stuck in an economic shampoo cycle: bubble, bust, repeat.
Source: Brookings Hamilton Project, Bordoff, Furman, Summers.
No industry has taken better advantage of the business interest exclusion than private equity investors like Bain Capital, which is Republican presidential frontrunner Mitt Romney’s former firm. Private equity is actually a misnomer, since the modus operandi of those investors is no different than the leveraged buyout firms that pioneered junk-bond financing in the 1980s. Private equity firms generally finance anywhere from 60 to 90 percent [my bold–JB] of their purchases with borrowed cash. Interest payments on those debts are treated just like any other expense, and are therefore deductible from earnings.
Moreover, Goozner cites research that the leveraged buyouts tend to be associated with cuts and job losses; spinoffs from larger conglomerates, on the other hand, tended to add jobs.
To be clear, I’m not saying this makes LBOs bad; sometimes, such cuts are necessary. But I am saying that any PE or hedge fund investor who says they’re in the business of job creation is spinning. They’re in the business of finding efficiencies at best, tax breaks and fast profits (at the expense of future growth) at worst.