In the context of corporate finance, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt than with equity. Under a majority of taxation systems around the world, and until recently under the United States tax system^{[citation needed]}, firms are taxed on their profits and individuals are taxed on their personal income.
For example, a firm that earns $100 in profits in the United States would have to pay around $30 in taxes. If it then distributes these profits to its owners as dividends, then the owners in turn pay taxes on this income, say $20 on the $70 of dividends. The $100 of profits turned into $50 of investor income.
If, instead the firm finances with debt, then, assuming the firm owes $100 of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $30. This implies for $100 of profits before taxes, investors got $70.^{[1]}
This taxrelated encouragement of debt financing has not gone uncriticized.^{[2]} For example, some critics have argued that the cost of equity should also be deductible; which could reduce the Internal Revenue Code's influence on capitalstructure decisions, potentially reducing the economic instability attributable to excessive debt financing.^{[2]}
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Transcription
In this video, I now want to cover one of the other most misunderstood ideas when people think about taxes, and that's the idea of deductions. So, one of the most common tax deductions is the deduction you get on interest on your mortgage. So let's say that this year on my mortgage of the part of my mortgage that is interest, let's say it's $10,000. It is $10,000 on my interest on my mortgage. And you'll either already know or someone might tell you that this is tax deductible. And the misconception that I've seen many, many times is that people think that since this is a tax deduction, that this $10,000 should be deducted from their taxes. So in the previous example, we showed the scenario where this person making $100,000 would have to pay $21,720 in taxes. And so based on that misconception, they would say, OK, I get a $10,000 tax deduction, now I would pay $11,720. And that is wrong. The deduction doesn't happen from the taxes you pay. The deduction happens from your stated income. So if this person right here had a $10,000 tax deduction, instead of saying that they made $100,000 that year, they would say that they made $90,000. So once again, the deduction does not come directly from the taxes. That would be a tax credit. The deduction comes from the reported income. So what would be the actual effect on the taxes? Well, we just have to look at this $90,000. It still kind of shows up in that top bracket. So the real difference is just going to be this $10,000 difference. Before, he was paying 28% on this $10,000. Now he won't have to pay 28% on that incremental $10,000. Another way to think about it, instead of this being 17,750 times 28%, it would now be 7,750. Because the reported income is now only $90,000. So the actual number we can get our calculator out and just calculate it. There's two ways you could do it. You could just say, look, if I'm going to have spent 10,000 if my income is deducted by 10,000, and I'm going to save 28% on that 10,000, you could just subtract 2,800 from this. But just to show you how it'll all work, that it all works out to the same thing, let's just go through the same calculation again. We have 7,750 times 0.28 plus 48,300 times 0.25 plus 25,600 times 0.15 plus $835. And it's $18,920. So now the taxes will be $18,920. And as you can see, the difference between the old and the new is exactly $2,800 because that's essentially what the amount that we would be taxed on that $10,000 if we had made that much money. Anyway, hopefully that doesn't confuse you too much.