A Case for Disallowing Interest Deductibility and Reducing Corporate Tax Rate

The tax deductibility of interest cost seems to be the major reason for the existing very high level of corporate borrowings in India. It is therefore suggested in this paper that interest cost may be disallowed as a deductible expense and simultaneously, the corporate tax rate may also be reduced in a way that not only the corporate sector’s tax burden remains unaltered but also the government does not suffer may loss of tax revenue. In view of the existing corporate tax rate of 60% and interest to profits before interest and taxes ratio of 40%, the proposed tax rate can, thus, be fixed at 36%, disallowing the interest deductibility. The proposed change would cause reallocation of the aggregate tax burden among companies. Thus, although the corporate sector’s aggregate tax burden would not change yet individual companies would be affected favourably or adversely. All profitable nonlevered companies would gain, saving 24% of profits as tax, buy the change. The hightly profitable levered companies, whose rates of return exceed two and a half times of their interest rates, would benefit more than the profitable nonlevered companies. The moderately profitable levered companies, whose rate of return are in excess of two and a half times of their interest rates into debt ratios, would also gain but less than the profitable levered companies. The less or marginally profitable levered companies would lese (they will have to pay more taxes) on account of the proposed change. Maximum loss will be suffered by the companies with low profitability and high leverage. Loss-making existing and new companies and sick companies would not be affected immediately as they do not incur any tax liability, but they would suffer when they would become profitable in the future and would not be allowed to carry ever the interest portion of the accumulated losses to be adjusted against profits for tax computation. All those companies which would suffer due to the proposed change should be given marginal reliefs at the time of the proposal’s implementation. Is the proposed change worthwhile? It is useful in two ways. First, a large number of profitable, levered and nonlevered, companies would immediately benefit as their tax liability would be reduced under the proposed system. What is more important however is that the proposed change would be in the long-term interest of all companies. By proposing a substantial reduction in the corporate tax rate (bringing it down form 60% to 36%), it potentially provides enough motivation for companies to improve their profitabilities by eliminating wasteful expenses and controlling costs. The change may thus help to increase the corporate sector’s profitability level in the long-run, and consequently, provide impetus to the capital market via improved share yields. Second, it would encourage a large number of moderately and marginally profitable companies to reduce their existing levels of debt to take full advantage of the proposed change. Thus the pressure for funds on financial institutions and banks may decline. Debt now would be a costly source of finance. As a result, unless a company is highly profitable, it would gain more and more (in terms of tax saved) under the suggested system by reducing its levels of debt. The proposed system may however tempt very highly profitable companies to employ more debt. The number of such companies is not large.