Tax Blog/Blawg

You might recall our prior post on the Wyden-Gregg tax reform proposal in which we discussed the proposed limitation on corporate interest deductions.  To summarize, the legislation would limit the deductibility of payments on corporate debt to the amount of the interest in excess of the annual rate of inflation, thereby discouraging the use debt to finance corporate operations.

We previously asked: “Why use inflation as the index for disallowing interest deductions, rather than simply disallowing, say, a fixed portion of the interest deduction?”  Thanks to the efforts of Greg Hillson, an enterprising 3L at UVA, we are now able to answer that question.  Mr. Hillson contacted an economist from the Senate Budget Committee who directed him to the 1984 Treasury proposal on which the interest-disallowance provision was based.    Fortunately, Treasury’s explanation of its original proposal gives a sensible explanation of why the portion of interest payments that is attributable to inflation should not be deductible.

As our readers know, neither the making of a loan nor the repayment of principal is generally considered to be a taxable event.  Generally, only the payment or receipt of interest on the loan is deductible or taxable, as the case may be (putting aside the satisfaction of a debt for less than the principal amount).

Yet, from an economic perspective, the payment of interest can actually represent, in part, the repayment of principal.  Consider that the nominal interest rate on a loan reflects a variety of components--e.g., a credit-risk component that compensates the lender for the risk that the loan might not be repaid, so that a less credit-worthy borrower pays a credit-risk premium relative to a more credit-worthy borrower.  Of primary importance here is the inflation component, which (to quote the 1984 Treasury explanation) “compensates the lender for the anticipated reduction in the real value of an obligation of a fixed dollar amount [due to inflation].”  Thus, “the inflation component of nominal interest payments is, in effect, a repayment of principal.”

Stated differently, there are two ways to account for the impact of inflation on the principal amount of a loan—(i) include an inflation component in the interest rate, or (ii) index the principal balance to inflation.  In theory, either mechanism should produce similar economic results of protecting the real value of the lender’s interest in the principal loaned to the borrower.  (Of course, in practice, the outcomes are much messier; but that is beyond the scope of this post.)  Thus, as noted above, the payment of the inflation component of interest is economically equivalent to the repayment of an inflated principal amount.

In sum, there is a principled basis for suggesting that the portion of interest payments that is attributable to inflation should be disallowed as a deduction.  Nevertheless, two further questions are raised:

(1)    By the same theory, recipients of interest (i.e., lenders) should be permitted to exclude from their gross income the same inflation component for which no deduction would be allowed to the payers of such interest (i.e., borrowers).  that was part of the 1984 Treasury proposal.  Query why it has been omitted from the Wyden-Gregg bill.

(2)    How should periods of deflation be handled?  If, during periods of inflation, interest deductions should be limited because the payment of interest reflects, in part, the repayment of principal; during periods of deflation, interest deductions should be extended above the amount of interest paid under the same reasoning.