08 Nov 2017 Aligning Infrastructure and Tax Reform in Tax
By Michele Nellenbach
Last week, Rep. Kevin Brady (R-TX), Chairman of the House Committee on Ways and Means, released his proposal to reform the nation’s tax code. Included in his proposal is a new limit on the deduction businesses can take for interest costs. The amount of interest expense deductions a company could take would be capped at 30 percent of a business’s earnings. Such a limit is intended to raise revenue, helping to offset the cost of dropping the corporate tax rate to 20 percent, however, proponents argue that it would address concerns that the current deduction encourages debt over equity financing, distorting business decisions, and enables corporate profit-shifting.
While the Chairman’s goal of addressing these concerns and simplifying the tax code is laudable, this particular provision may have an unintended consequence that could make it harder to raise private capital to address our nation’s $1 trillion infrastructure funding gap.
President Trump has advocated for a $1 trillion increase in infrastructure investments and his staff is currently pulling together a package. It is widely expected that the promotion of public-private partnerships (P3s) will be part of any federal infrastructure package. While P3s are not the answer for every project, they can transfer the risks associated with cost overruns and construction delays to the private investor. For example, Pennsylvania’s Rapid Bridge Replacement Project was contracted through a private consortium to repair and upgrade 558 rural bridges. The consortium is completing the bridges faster and at a lesser cost than the state would have been able to do.
Private sector investment in public infrastructure often results in the private investor taking on large amounts of debt at the beginning of the project in order to make the necessary upfront payments to build or acquire the asset. The private investor recoups its investment and pays off its debt over a longer period of time as it achieves modest but stable and long-term returns on its investment. Limiting the interest deduction in such a situation could make these projects uneconomical for private investors. Often, the private investor has large interest payments on its debt and relatively low earnings during the first few years of a project.
Simplifying the tax code is important, however, it should not be done at the expense of the type of infrastructure investments the nation needs.
For example, a $1 billion bridge project with the company financing with 50 percent equity and 50 percent debt, and the investor in the project is paying 8 percent per year in interest on its debt. Thus, the investor has $40 million in annual interest expense. In order to be able to deduct the full $40 million in interest expense, the investor needs to have at least $133 million in earnings. Earnings less than that would mean that the $40 million in interest would exceed 30 percent of the investor’s earnings. Not many P3s will bring in $133 million a year in the first few years; if they did, we’d have a lot more P3s in this country.
Recognizing the potential for such an interest deduction limitation to render private investment in public infrastructure uneconomical, other countries with similar interest deduction limitation policies have crafted their deduction limits to avoid this problem. One of those countries is the United Kingdom, where the debt incurred as part of specific infrastructure projects – ones with a clear public benefit – can be exempted from the cap.
Simplifying the tax code is important, however, it should not be done at the expense of the type of infrastructure investments the nation needs.
One of the reasons for tax reform is to catalyze economic growth, an important goal of those advocating for a federal infrastructure package. These two vehicles for economic growth can and should work in tandem. Tax reform involves complicated policy tradeoffs with winners and losers in virtually every proposed change.
As members of Congress move forward with tax reform, they should be mindful of potential impacts on other important policy goals and maintain the earned interest deduction for infrastructure projects.
