> Let me put that differently: is there any justification in
> economic theory for not charging corporations tax on their interest
> payments? It seems to me that mainstream economists should consider this
> a distortion, since in pure theory, corporations should only borrow when
> the cost of capital is lower than the expected profit.
It is a distortion. But there's a timing disconnect between the cost of capital and the definition of expected profit. You could call it - meeting quarterly earnings. For example, for many of the most leveraged telecoms - who were dodging taxes at every opportunity, not just on debt interest payments but by relocating headquarters or revenue producing subsidiaries off-shore: projected profits had nothing to do with reality. In fact, profits were declining as borrowing was increasing, but projections were not.
The volume of corporate debt issuance quadrupled over the last 6+ years compared to the first 6 years of the 1990s. Corporate borrowing via bond issuance amongst the already most leveraged institutions spiked in 2001, even as the stock market was tanking, because of Greenspan's 11 time rate cut gift - capital was cheap. It still is, but issuance, or borrowing, has deteriorated substantially over the past year, because there aren't enough investors to 'take down' that debt. And higher corporate defaults rates don't help.
Generally, when a syndicate of banks opens a credit facility, or revolving loan facility for a corporation, the justification is that whatever the corporation does with the new capital it receives, it will be met with increased revenue. During the late 90s, the biggest syndicated loans were offered in conjunction with mergers or acquisitions, kind of a twisted doubling down logic. The bigger the corporation, the more credit worthy it is. Only that was and still is clearly not the case. Not only have we witnessed a meltdown of the highly leveraged telecom industry, but many of the most debt-laden energy corporations are about to join suit - I can think of about eight who'd be hard-pressed to withstand a 5-10% additional fall in stock values.
Theoretically, that's one of the things a bank's capital markets issuance department is supposed to verify - true creditworthiness before they issue new debt. But, in my experience, that never happened. More like, well if our competitors are raising financing, we have to keep up. A very short term view. And a very dangerous one, time and time again.
Back to the justification issue, whereas not economic, not taxing interest suits every corporation and the entire banking community over the short term (a multi-billion dollar lobbying contingent). That's if companies don't default. The fact is over the past two years, default rates have reached a level only last seen during the S&L crisis (though defaulted volumes are larger). The only other time default rates were higher was during the great Depression. It would be prudent to curtail debt piling by taxing interest rates for corporate issuers (though they'd hate it) and investors (who'd hate it because their received interest would probably be decreased to offset the tax, but they'd be more protected by investing in less leveraged companies, who'd have to think harder about debt accumulation). But prudency doesn't seem to be a consideration.
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