Are there benefits for business debt being tax-favored?

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pohnpei397 eNotes educator| Certified Educator

In the corporate world in the United States, debt is favored relative to equity in terms of taxation.  Dividends paid out to a firm’s stockholders are taxed more heavily than interest payments to the firm’s debtors.  This encourages businesses to borrow money rather than to do things like raising money through the stock market or buying capital goods with cash.  There are some benefits to this.

First, it is a bad idea to tax interest because interest is really a form of business expense.  We would not want to tax firms on their gross revenues rather than their net revenues.  If we want to avoid this, we cannot tax interest because interest is part of what the business pays out in operating expenses.

Second, if we taxed debt, firms would find ways around outright borrowing.  They would still borrow, but would do so in ways that were less straightforward.  This would raise their expenses because they would be doing things in a less efficient way than if they simply borrowed money like they do now. 

For these reasons, it is beneficial to favor debt in the tax code.