Paul L. Caron

Wednesday, May 11, 2022

Hasen: Interest Deductibility

David Hasen (Florida; Google Scholar), Interest Deductibility:

The proper tax treatment of interest expense has been a subject of disagreement since the inception of the modern income tax in the early twentieth century. On one view, the purpose of the financing transaction dictates the tax treatment of interest so that interest paid on borrowing used to finance consumption should be nondeductible, whereas business interest should be deductible. On another view, interest paid does not finance a consumption item but rather a mere shift in resources and therefore should be deductible at all events, assuming the recipient includes the interest received in income.

Both of these views lead to conundrums that cannot be resolved without considering the broader question of why some expenses are deductible at all. Focusing on that question, it turns out that business interest, like any other business expense, should generally be deductible as a timing or an accounting principle under an income tax. That principle does not apply to personal interest expense. Nevertheless, there may be an independent basis to permit a deduction for personal interest expense that is grounded in considerations of vertical equity.

A related question arises when loan proceeds finance the purchase of business assets that are taxed under consumption tax principles. Congress has lately sought to limit interest deductibility in this setting because of the arbitrage benefit that it provides, but a better approach would be to apply consumption tax principles more consistently to the overall arrangement. Such an approach would keep business interest deductible, but loan proceeds would be includible in gross income in whole or part.

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