Corporate Meltdowns and the Deduction of Credit Risk Interest

Abstract

Corporate equity is like an option for big, high volatility investments because shareholders get all the gains but shift some of the losses to creditors by defaulting on the debt. That asymmetry allows shareholders to improve their position by increasing the volatility of corporate assets. In doing so, however, they impose losses not just on creditors, but also on employees, suppliers, customers, and the economy at large. It would be far better not to induce high risk in the first place.

This proposal would disallow the deduction of credit-risk interest that covers the risk of default. Because the credit-risk interest is an assessment of how likely it is that the debt will not be paid, it tracks the protection against loss that gives equity its optionlike character. Risk is an equity-like feature of an instrument. Current law’s attempt to distinguish debt from equity is a quagmire. Disallowing the extra credit-risk interest is a gradual, fair, and administrable way to separate debt features from equity.

This proposal is as part of the Shelf Project, a collaboration among tax professionals to develop proposals to raise revenue by defending the tax base. Shelf Project proposals raise revenue without a VAT or a rate increase in ways that would improve the fairness, efficiency, and rationality of the tax system. Shelf projects are intended to foreclose both 85 percent income tax rates and 60 percent federal sales.