Tax Deductibility of Interest Payments: Political Reasons for the Preferential Treatment of Debt in European Tax Systems

Abstract

Most corporate tax systems in the world have in common that debt is treated favorably due to an allowance of interest deduction. This causes a so-called “debt bias” in modern tax systems. In literature the implications of this taxation habit are broadly discussed. The political dimension, however, has been hardly regarded. This work aims to make a contribution to fill this gap by identifying the political reasons of the maintenance of the deductibility of interest payments. I found that the Theory of Path Dependency as well as the Interest Group Theory might serve as explanation. By means of these theories a case study of Italy and the United Kingdom was conducted. In terms of the Interest Group Theory, I argue that family-owned businesses are a pressure group that aims at maintaining the tax advantage of debt. This group has the greatest ability to capture policymakers in countries that are prone to corruption and in which such a type of business is prevalent. Furthermore, I argue that the financial industry as another pressure group cannot unify their interests. Thus, in countries that have set their economic focus on financial services, policymakers are not captured and directed in a clear direction. As a result, slack-reducing crises that put pressure on a political system have a sharp effect on captured political systems. On the other side, the Theory of Path dependency provides a better explanation in the case of less captured countries. I argue that in those countries learning effects are triggered by exogenous shocks with a result of smooth adjustments of policy outcomes towards an efficient taxation system.