The Historical Origins of the Debt-Equity Distinction

Abstract

The U.S. tax code favors corporate debt over corporate equity, a distinction long criticized by economists, legal scholars, and other tax commentators as both theoretically and practically unsound. For decades, academics and policymakers from a variety of disciplinary and political backgrounds have argued that this so-called “debt-equity distinction” distorts corporate financing decisions, encourages excess borrowing, and invites troublesome tax-avoidance behavior. Surprisingly, despite widespread critical attention, the origins of this policy remain a mystery. Primarily focused on its contemporary significance, scholars have disregarded the distinction’s past.

This article uses historical evidence to trace the debt-equity distinction’s origins, development, and continuing evolution. Citing legislative history, business lobbying efforts, and important changes in the broader historical context, it argues that the disparate treatment of debt and equity was never a conscious policy goal, but was rather the unintended outcome of an extended series of short-term political decisions. These political decisions were historically specific — i.e., formulated in response to temporary historical contingencies — but had consequences that have persisted to the present day. The article concludes by assessing the broader implications of this history for both the current structure of the U.S. tax system and the prospects of future tax reform.

Keywords: legal history, income taxation, corporate finance

JEL Classification: G3, H25, N40