The resulting [tax] rate on equity-financed corporate capital income is 36.1 percent and that on debt-financed corporate capital income is -6.4 percent, a difference of 42.5 percentage points. The rate on equity-financed corporate capital income is higher than the statutory corporate tax rate because of the extra tax imposed on dividends and capital gains at the individual level.
Obviously, this will steer corporations towards debt financing over equity financing. Some quick definitions: equity financing is financing by issuing stock, i.e. financing from your shareholders; while debt financing is done by borrowing. Firms typically use a mix based on their individual needs. The important point is that the tax code is quite probably influencing corporate decision-making for the worse and distorting capital markets.
So is this a case of a tax cut with negative consequences? Milton Friedman once said:
I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible.
My preferred solution is to cut all tax rates drastically. But assuming we have some situation where our only choice is a 36.1% tax rate for both debt and equity financing, or 36.1% for equity and -6.4% for debt; is the best solution to have both at 36.1%, as this probably causes less severe market distortions?
As always, we welcome your thoughts.