2012 William & Mary Business Law Review Best Student Note Award
This Note identifies the failure of Congress to address tax incentives for leverage as a principal cause of the recent financial crisis and a fundamental flaw of recent financial reform legislation. Specifically, the Internal Revenue Code provides substantially disparate tax treatment for debt and equity financing by allowing firms to deduct interest payments on indebtedness, but not providing an equivalent deduction for equity funding. This “debt-equity distinction” artificially reduces the cost of capital for debt financing relative to equity financing and encourages firms to over-employ leverage in their capital structure. This in turn increases financial distress costs and externalities to the economy and increases the volatility of capital markets. Though some scholars have proposed to allow firms a deduction for dividends paid, such a scheme would create additional distortions and introduce the potential for corporate managers to substantially manipulate their taxable income. This Note offers an alternative solution by proposing: (1) that the deduction for interest on business indebtedness be eliminated, and (2) that policymakers return to the idea of the Cost-of-Capital-Allowance (COCA). A COCA deduction better aligns the incentives of firms with those of capital markets and economies writ large, and encourages managers to seek out the absolute cheapest sources of capital while removing tax shelter considerations from the decision-making process.