The Tax Cuts and Jobs Act (TCJA), signed into law last December, contains provisions related to the deductibility of interest expenses. As the authors of an analysis from the New York Fed’s Liberty Street Economics blog explain,
Through 2021, net interest expense is only deductible up to 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA). Starting in 2022, net interest expense is only deductible up to 30 percent of earnings before interest and taxes (EBIT). Mitigating these caps is the fact that interest expense above the cap can be carried forward indefinitely.
By limiting the deductibility of interest payments, TCJA makes it more expensive to finance using debt, a positive development. Debt financing is risky, as recent history has shown us. And, due in part to the preferential tax treatment of debt financing, it’s difficult for firms to deleverage on their own. By encouraging firms to deleverage, this part of TCJA is a welcome change of pace.
But what if these firms don’t take the hint and deleverage? The authors at Liberty Street believe this will increase the cyclicality of bank capital and worsen the effects of an economic downturn.
In the short run, if corporate leverage does not change, the new tax code will tend to make bank capital and nonbank defaults more cyclical, particularly in a severe downturn. In the long-run, the increased cyclicality could be mitigated by deleveraging if firms respond to the lower corporate tax rate, new limits on net interest expense deductibility, and heightened cyclicality of after-tax cash flows, which potentially increase the probability of distress. If firms trade off the marginal costs and benefits of debt as in corporate finance theory, optimal leverage for nonbanks should fall under the new tax law.
There is evidence that firms change their leverage decisions in response to relevant tax policy changes, but these changes come slowly. More aggressive policy changes to encourage deleveraging, such as higher capital requirements, would do a better job reducing the systemic risk in our financial sector.