The Deduction of Interest Payments in an Ideal Tax on Realized Business Profits

Abstract

For the most part, the need for capitalization in a realization system is well recognized by policy makers and tax analysts alike. The broad consensus breaks down, however, with respect to interest payments. Some tax analysts argue that interest is inherently a current expense and ought to be deductible currently except in rather special circumstances. This viewpoint apparently is widely accepted in accountancy. Whatever the views of tax analysts and accountants may be, the simple fact is that all countries imposing a tax on business profits fail to apply to interest payments the capitalization rules that are routinely applied to other types of rental payments. This permissive and special treatment of interest payments compromises the integrity of a tax on realized income and results in the substantial undertaxation of business profits around the world. Part I of this paper raises and offers answers to questions that go to the foundations of the income tax - indeed, to the foundations of any broad-based redistributive tax. In that part, I analyze the policy goals and basic features of an ideal or model tax on realized income. I conclude that an ideal realization tax has some significant practical advantages in taxing business income over either a Haig/Simons income tax or a Kaldor/Andrews consumption tax, whatever the relative merits of a realization tax may be in some utopian world of our imagination. In particular, I argue that a realization system is better able to deal with certain realities - valuation issues and cross-border issues - that alternative income and consumption tax systems do not deal with very well. I examine in Part II the proper treatment, in a tax on realized income, of interest costs incurred by a taxpayer engaged in business activities. In brief, I argue that interest costs should be treated in much the same way that other types of rental costs are treated. For example, interests costs incurred to acquire or produce inventory property should become part of the cost of goods sold and should not become deductible until the income from the sale of the related inventory property has been realized. In addition, interest payments traced to income that is not subject to current taxation because it has been earned through a foreign affiliate should not be deductible until the related income has been realized. A proper system for capitalizing interest payments would reduce substantially the bias in favor of debt-finance investments over equity-financed investments found in all income tax systems.