Should interest expenses be tax deductible?

- If interest expenses are not tax deductible, firm leverage and riskiness decrease.
- Shareholders would lose 3.5% of their investment as tax shield disappears.
- The government's revenue from corporate income tax would increase by 3%.
- The increase in government revenue is due to the reduced number of firm insolvencies.
- The current period of low corporate bond yields is the best time for the reform.

This paper analyzes how shareholder wealth, firm characteristics, and public finance would be impacted if tax deductibility of interest expenses were eliminated. We find that shareholder value would decrease by 3.5%. Under the new regime, firms would be smaller and less levered, would have less productive capital, and would feature lower default probabilities. The effects on aggregate output and employment would be negative. However, the government's revenues from corporate income tax would increase by 3% in the long-run and could be used to partially offset the negative side effects of the reform. The current period of historically low corporate bond yields is probably the best time to change the treatment of interest expenses.