What is meant by saying debt is tax favored?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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In the corporate world in the United States, it is said that debt is favored relative to equity.  That is, it is beneficial in tax terms for firms to raise money through debt rather than through the stock market.

When a company raises money through the stock market, it essentially is subjected to being taxed twice.  First, the company’s profits are taxed as part of the corporate income tax.  The company then typically takes its remaining profits and pays them out to its shareholders in the form of dividends.  These dividends are also taxed.  In this way, the money the firm is making and distributing is taxed twice.

This is in contrast to debt, which is only taxed once.  When the firm makes money, that money is taxed.  However, when the firm pays interest to its creditors (which could be seen as similar to paying dividends to shareholders) the interest is not taxed.  In this way, interest payments on debt are treated differently than dividend payments to shareholders.  This is why debt is said to be tax-favored in the corporate world.


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