As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States enacted a new limitation on interest deductions for businesses. While it is common for countries across the Organization for Economic Cooperation and Development (OECD) to set limits for interest deductions, starting this year, the U.S. became an outlier by using earnings before interest and taxes (EBIT) as the limit’s tax base.

The change effectively tightens the limit for U.S. firms just as interest rates are rising, creating a tax increase for many firms. A better approach would be to reconsider the potential economic fallout of this change and re-establish EBITDA as the interest limit, consistent with international norms.

Countries may limit interest deductions for several reasons: for example, to reduce tax avoidance through shifting of debt across borders from low-tax subsidiaries to related firms in high-tax jurisdictions, and to help equalize the tax treatment of debt-financed investment compared to equity financing (the expense of equity finance is generally non-deductible).

There are several types of limits for interest deductions, known as thin capitalization (henceforth thin cap) rules. One option is to limit deductions based on transfer pricing regulations that apply to interest rates. Other limits include safe harbor rules, which create a debt-to-equity ratio where the interest paid on debt exceeding the ratio is not deductible. Earnings stripping rules establish a limit based on a share of pre-tax earnings such as earnings before interest, taxes, depreciation, and amortization (EBITDA).

Several studies have shown that thin cap rules

can have various adverse economic effects, such as less investment, decreased employment, and lower market values of firms. When designing thin-cap rules, countries are therefore facing a trade-off between adverse economic effects and limiting base erosion. At the same time, depending on the design of the rules, they might also decrease debt bias. If thin-cap rules are introduced to reduce the debt bias, however, measures that incentivize equity financing, such as allowances for corporate equity, can also be effective.

Under the U.S. federal tax code, businesses are permitted to deduct net interest payments for debt against their taxable income up to certain limits. From 2018 through 2021, the limit was set at 30 percent of EBITDA.

As of the beginning of this year, the net interest deduction limitation tightened to 30 percent of EBIT, dropping depreciation and amortization from the calculation. Put simply, this means a firm at the previous limit using EBITDA must reduce their deductions by 30 percent multiplied by their depreciation and amortization costs. This represents a significant tax increase for many firms—especially capital- and R&D-intensive firms with relatively high debt loads—and it comes at a perilous time with the economy weakening across several sectors due to rising interest rates (which itself subjects more firms to the limit).

This change also increases the tax barrier to new investment. Kyle Pomerleau at the American Enterprise Institute finds the tighter interest limitation increases marginal effective tax rates on new investment by 0.5 percentage points for corporations and 0.1 percentage points for pass-through businesses.

Looking across the OECD, the U.S. limit using EBIT stands out as an outlier. 26 OECD countries use EBITDA as an earnings stripping limit (see table below). Notably, no country in the OECD uses an EBIT-based limitation.

One reason many European countries have adopted a limit based on EBITDA is because of the European Union’s Anti-Tax Avoidance Directive, which established EBITDA as the shared definition for interest limitations across the EU as part of the base erosion and profit shifting (BEPS) project. The most common limit is set at 30 percent of EBITDA across the EU, along with separate safe harbor and transfer pricing rules.

While there is disagreement about the amount of interest that should be deductible, it is clear that the limit based on EBIT makes the U.S. an outlier compared to other countries across the OECD while imperiling many firms and raising the cost of new investment.

Policymakers should consider restoring EBITDA for the interest limitation threshold. Later, this could be made consistent with any chosen level of deductible interest.