In the heat of the presidential race, few noticed a suggestion from President-elect Donald Trump that would, if put into practice, be a game-changer. Among the footnotes to the planned cut in the headline corporate income-tax rate from 35% to 15% was a proposal to scrap the tax deductibility of interest expenses. This is an idea whose time has come.
This tax rule provides enormous support for the use of debt in corporations and has helped fuel a debt bubble and concentrated the ownership of equity both of which lie behind much of the political angst we see today. The so-called debt shield subsidises the returns to equity for the few who have it and it discourages business owners from using equity finance that would more broadly distribute the financial rewards of their success and stabilise their companies.
Scrapping the debt shield is not a new idea. A presidential panel on tax reform proposed this in 2005, while in 2011 an IMF economist said it clearly created "significant inequities, complexities and economic distortions". The European Commission concluded much the same in 2012. But with one or two exceptions Germany capped the deductibility of interest in 2008 this has not yet had much impact on policy.
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Promises of tax reform in the US are notoriously difficult to keep. George H W Bush found himself supporting several tax increases in 1990 despite his "Read my lips: no new taxes" promise two years earlier. However, Trump has the Republicans in control of both congressional chambers and will find many supporters if he pushes for the change the House Republicans' "A Better Way" plan, led by Speaker Paul Ryan, had the debt shield as one of its five key targets with respect to taxation.
Trump's proposal is also wrapped up with another footnote that is politically more difficult to oppose: allowing the immediate expensing of business capital expenditure. This will, in theory at least, create jobs by encouraging investment. Cutting the tax deductibility of interest might also make sense from a fiscal standpoint: one study by Robert Pozen suggests that limiting the tax shield by just 30% would allow the standard rate of corporate tax to be reduced to 25% while still maintaining the overall tax take.
So what might the implications be from an investment perspective? Tax accountants would be tied up for years figuring out the impact company by company, so it would be wrong to make specific calls at this stage. International profits would be exempt from the change unless other jurisdictions followed suit and the actual utilised debt shield is not totally clear at the company level. It's fair to assume, however, that the most leveraged companies would see the biggest negative impact on earnings.
To sense the degree of that hit, Equitile looked at around 300 companies from the S&P that were profitable in 2015. Assuming none of their interest costs were deductible, the most leveraged quintile would have seen an 11% cut to net earnings. Even the more modestly leveraged second quintile would have seen an 8% cut to net earnings. Only the most conservatively financed cohort would have seen little to no impact. If the debt shield were eliminated, the impact on earnings would be permanent until firms had adjusted their capital structures to reduce debt levels.
Much of what Trump has promised will not be delivered, but if this apparently innocuous detail becomes real, the outcome could be more resilient corporations and wider distribution of their profits. As far as investors are concerned, a cut in headline corporate tax could float all boats but they might be advised to check the footnotes.
Andrew McNally is chief executive officer of Equitile Investments
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