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‘Profit’ is a meaningless term

Summary:
Most people believe they understand what the term ‘profit’ means. It’s a measure of revenue minus costs. Actually, however, profit is a pretty meaningless term, because there is no clear definition of “cost”. I was reminded of this when reading a debate in the Financial Times that discussed whether interest payments should continue to be tax deductible for businesses. The person opposed to ending the tax deductibility of interest made the following claim: No — Tax should be paid on profits, not revenue It is a fundamental principle in the UK, US and most other jurisdictions that companies pay taxes on their profits, not on revenues, writes Jonathan Blake. It follows that businesses should be able to subtract legitimate expenses when calculating their taxable

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Most people believe they understand what the term ‘profit’ means. It’s a measure of revenue minus costs. Actually, however, profit is a pretty meaningless term, because there is no clear definition of “cost”.

I was reminded of this when reading a debate in the Financial Times that discussed whether interest payments should continue to be tax deductible for businesses. The person opposed to ending the tax deductibility of interest made the following claim:

No — Tax should be paid on profits, not revenue

It is a fundamental principle in the UK, US and most other jurisdictions that companies pay taxes on their profits, not on revenues, writes Jonathan Blake. It follows that businesses should be able to subtract legitimate expenses when calculating their taxable profits. The deductibility of employee, rental or inventory costs is uncontroversial — why should interest costs be different?

Readers may recall that I believe we should tax consumption, not “profits”.  But even if I’m wrong, I see no reason to make interest payments tax deductible.

Both interest and dividends are forms of capital income.  Interest is capital income earned on debt, while dividends represent capital income earned on equity.  It makes no sense at all to call one “profit” and the other a “cost”.  Nor does it make any sense to make one tax deductible but not the other.

If neither interest nor dividends were tax deductible, then we could have lower tax rates and still achieve the same revenue target.  Treating the two equally would also lead to relatively more equity and less debt, reducing the severity of financial crises and making our economy more stable.

Again, I’d prefer not taxing profits at all.  But if we must tax profits, then let’s do so in the least inefficient way possible.  And most of all, let’s not justify our highly flawed tax system by pointing to mythical concepts such as “profit”.

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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