The debt tax bias is smaller than you might think
Under prevailing American tax law, a firm that wants to pay a dividend to its shareholders needs to pay with after tax dollars while a firm that wants to pay interest on a loan gets to pay with pre-tax dollars. Since the statutory corporate income tax is pretty high at 35 percent, this is a pretty big deal.
The difference in the tax treatment of interest and dividends is, of course, not 35 percentage points.
If a US corporation $100 of operating profit in interest, that money is not taxed at the corporate level. The debtholder, however, has to pay ordinary income tax on the money, at a top rate of 39.6% for individuals making more than $400,000 in 2013, so the debtholder gets $60.40.
If it is instead retained as profits and eventually paid out as a dividend, the profit is taxed at a top rate of 35% at the corporate level, so $65 is paid out. That income is in turn taxed at a top rate of 20%, so the stockholder ends up getting $52, for an overall tax rate of 48%.
This means there’s an 8.4 percentage point difference between debt and equity in how a dollar of profit is taxed from when it is made until an individual capitalist can receive it. That’s still a hefty subsidy for debt, but not as high as a naive reader of Matt’s post might think.
The figure is different for people in different tax brackets. It gets really complicated if debtholders and stockholders tend to be in different tax brackets or if you consider investors such as pension funds that are taxed in weird ways.