The tax treatment of debt and equity

Differential tax treatment of debt and equity finance is difficult to justify on economic grounds as it creates various distortions, but is nevertheless widely observed. It is clear that treatment varies considerably across countries due to differences in the legal  definitions of debt and interest. Reform could be achieved through introducing an allowance for corporate equity (ACE) or a comprehensive business income tax (CBIT). In the absence of such a radical reform, coordination of the legal definition of debt and interest for tax purposes across countries would help to reduce international tax arbitrage and administration and compliance costs.

What would be the effects of equalising the treatment of debt and equity?

This project explores two ways in which the treatment of debt and equity could be equalised. Equity could be more generously treated, with an allowance for corporate equity (ACE). Or interest relief could be restricted, as under a comprehensive business income tax (CBIT). This project assesses the effects of each of these reforms if implemented in the EU. The results suggest that ACE would improve welfare if corporate tax rates were not increased to cover the cost of the narrower tax base. By contrast, under the same conditions CBIT would typically reduce welfare by exacerbating marginal investment distortions. However, if the tax rate were adjusted to make either reform revenue-neutral, the CBIT becomes more attractive and the ACE less attractive. European coordination of reforms mitigates tax spillovers within the EU and makes ACE more, and CBIT less, attractive for welfare. A combination of ACE and CBIT reforms can be designed to be revenue- neutral, and which would improve welfare through smaller financial distortions.

Michael Devereux