End Corporate Debt Bias — and Expand School Choice

December 1, 2014 • Cato Online Forum
By Reihan Salam

Though the cultural prestige of entrepreneurship in the United States is as high as it’s ever been, the sobering truth is that the country is suffering from a dearth of high‐​growth firms. The entrepreneurs of the moment gravitate towards the least‐​regulated sectors of the economy, where barriers to entry are low and headaches are relatively few. The trouble is that these are also sectors where the opportunities to deliver big employment gains have also proven fairly modest, or at least they have so far.

In the normal course of events, we expect job destruction and job creation to move roughly in tandem, with job creation surpassing job destruction just enough to keep employment levels rising. One of the main drivers of net job creation is the emergence of new business enterprises. When new enterprises fail to emerge, it should hardly be surprising that net job creation suffers — and indeed, that it will go into reverse, as it did in the wake of the Great Recession.

How is it that new firm creation contributes to net job creation? To oversimplify matters, successful new enterprises tend to bring with them new ways of doing business, which force older firms to either adapt or go out of business. Yet these new business models also create new employment opportunities. The rise of the automobile may have devastated the horse‐​and‐​buggy economy, but it also led to the establishment of filling stations, quick‐​service restaurants, motels, and all manner of other businesses that have automobile‐​enabled customers at their core, not to mention all of the businesses that were supercharged by automobile‐​enabled workers. We’ve grown accustomed to thinking about (some would say dwelling on) how various labor‐​saving innovations destroy jobs. What we neglect is how labor‐​saving innovations can free up workers to take on new challenges and solve new problems.

There are many steps we could take to make life easier for entrepreneurs. But if given a magic wand to make a single policy change, I’d start with the so‐​called corporate debt bias. Because interest payments are deductible while the cost of raising equity capital is not, the tax code all but begs companies to borrow. While the effective tax rate on corporate investments financed by debt is effectively negative, the rate on investments financed by equity is quite high. This would make sense if there were some compelling public policy reason to finance corporate investments with debt rather than equity. If anything the opposite is true. Debt is not a bad thing in itself. But too much debt can make firms, and entire economies, more fragile.

There is another, subtler dimension to the corporate debt bias. Yes, it lures firms into making debt‐​equity decisions that they might not make if they were only looking at the economic fundamentals. It also gives a boost to incumbent firms that, by virtue of their track record, are in a much better position to borrow than untested start‐​ups. Even in the absence of the corporate debt bias, start‐​ups face a less‐​than‐​level playing field when they decide to take on established players. If our goal were to squelch start‐​ups in the crib, the debt bias would be a great way to finish the job. So let’s get rid of it.

Having tackled the corporate debt bias, I’d next want to address another innovation bottleneck: our public education system. Dartmouth College economist Andrew Samwick has proposed a modest tax reform that could have an enormous impact on how American educate their children. When parents choose not to send their children to local public schools, they are in effect making a cash gift to state and local taxpayers, as they are foregoing a claim on public resources. Samwick argues that we ought to treat this gift the way we treat other charitable donations. That is, he wants to give these parents a tax break. Some will no doubt object that by encouraging affluent parents to withdraw their children from local public schools, Samwick’s proposal will exacerbate inequality. But by expanding the market for private education, Samwick’s tax reform will create an opening for educational entrepreneurs open to serving a more economically diverse clientele.

In a similar vein, I would encourage all public schools to move towards course‐​level instructional choice. That is, instead of simply choosing one school or another, students would be given a K-12 spending account that they could use to purchase a range of educational services, as Burck Smith, the CEO of StraighterLine, has proposed. If a student chooses a lower‐​cost online Mandarin course over taking Spanish from the teacher offered by her high school, she could use some of the savings to pay for English tutoring, or to add to her college savings account. This would encourage productivity‐​enhancing course‐​level innovation and it would encourage spending discipline on the part of students, parents, and educators.

Reducing the corporate debt bias would be politically difficult. Changing the tax code to encourage parents to abandon their local public schools would be, for all practical purposes, politically impossible, as would empowering students and parents to choose lower‐​cost educational options that would slowly drive ineffective teachers and administrators out of business. But these are the kinds of institutional reforms that would, over time, deliver serious growth dividends.

The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.

About the Author
Reihan Salam