Are there risks 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.  What this does it to push firms to borrow to fund themselves rather than selling stocks.  There are negative consequences that go along with this choice.

There are at least three types of negative consequences of debt being tax-favored.  First, companies that incur debt are less likely to be innovative.  They are less likely to do risky things and to expand.  This hurts our economy because companies that take risks create the innovations that drive our economy.  Second, companies that have heavy debt loads are more susceptible to bankruptcy.  What this means is that they are less resilient and more likely to fail if the economy goes bad.  If that happens, the firms’ troubles magnify the economy’s troubles.  Finally, firms sometimes, instead of paying dividends, keep their money and use it to do their own investing.  These firms often make bad investments and weaken themselves.

For all of these reasons, having debt be tax-favored can be harmful to firms and to our economy.