Trump Proposes Bringing Back the Deduction for Auto Loan Interest
Alex Brill, Kyle Pomerleau and Stan Veuger | AEIdeas
During a recent speech at the Detroit Economic Club, former President Donald Trump proposed partially renewing a tax policy in effect prior to the Tax Reform Act of 1986 that allowed taxpayers to fully deduct interest expense on auto loans. He asserted that the change would “stimulate massive domestic auto production and make car ownership dramatically more affordable for millions and millions of working American families.” In principle, there is nothing wrong with allowing taxpayers to deduct interest expense if interest income is taxable. However, moving in this direction for auto loans comes with notable downsides.
The payment of interest is simply a transfer from one taxpayer to another and does not generate additional net income for the US economy. Thus, under a pure system of income taxation, if a lender’s interest income is taxable, the borrower should receive an offsetting deduction. In theory, interest deductions will equal interest income and the government will place no net burden on borrowing and collect no net revenue.
However, the US income tax is anything but consistent in this regard. While most interest income is taxable apart from interest on municipal bonds and a handful of private activity bonds, consumer interest expense is generally not deductible (aside from some mortgage interest). Business interest expense for both corporate and noncorporate businesses is generally deductible subject to certain limitations.
While restoring the deduction for interest paid on auto loans might be consistent with an overall more coherent treatment of interest, it would be unwise for a few reasons.
First, in the real world, borrowers and lenders often have different tax rates and therefore a deduction by the borrower is often not perfectly offset by the inclusion of interest income by the lender. This results in some borrowing facing a net tax burden and other borrowing facing a net subsidy. For example, a taxpayer that borrows from a credit union could deduct the interest expense at a rate up to 37 percent, but the credit union, which is exempt from income taxation, would face no tax on their net interest income. This transaction would simply result in a revenue loss for the federal government.
Second, allowing a deduction for auto loan interest, but not other consumer debt would create distortions across different goods and services. This, of course, is a necessary condition to meet Trump’s stated goal: to bolster the domestic auto industry. Whatever one thinks about the merits of this goal, much of this tax cut would be “wasted” on imported cars, which account for roughly half of all US car sales. Moreover, it is unclear how much this policy would actually reduce the net cost of purchasing a car. It could also bid up car prices and/or the interest rate on auto loans.
Third, and as is the case with all recent Trump tax proposals, it could meaningfully reduce federal revenue. The revenue implications of the proposal will depend heavily on the design. If Trump restores the itemized deduction for interest expense for automobile financing, the benefit would be limited to those who itemize and would reduce federal revenue by $76 billion over 2025–2034. Such an approach, while not overly expensive, would be rather ineffective in bolstering car sales as roughly one in 10 car buyers with an auto loan would benefit. In contrast, if the deduction were more widely available to households as an above-the-line deduction, it would reduce revenue by $175 billion. In short, this is yet another policy that could at best crowd out higher priorities in next year’s tax debate.
Although this particular policy creates more problems than it solves, a broader reform of the tax treatment of interest may be worthwhile. One option would be to eliminate both the deduction for all interest expense and the taxation of all interest income. Fundamental reforms such as the Flat Tax or X-tax would treat interest this way. The Tax Cuts and Jobs Act (TCJA) moved in this direction by limiting the deduction for business interest expense. Short of this type of reform, Trump should shift his focus back to the expiring provisions of the TCJA.
Read the blog post here. Find other articles about the presidential election here, here and here.