"The current tax code encourages corporations to finance themselves with debt rather than equity," said the 23-page plan. "The tax preference -- outsize reliance on debt financing -- can increase the risk of financial distress and raise the risk of bankruptcy," increasing the risk of "destructive asset sales" or "high risk negative economic value investments."
The plan urged reducing that bias toward debt financing. "A tax system that is more neutral toward debt and equity will reduce incentives to overleverage and produce more stable business finances, especially in times of stress."
Lessening interest deductibility would boost the cost of financing leveraged buyouts and lower private equity investment returns. Tax experts said Wednesday that the debt changes could have other significant impacts on corporate and deal financing as well.
"You can make equity more favorable by not taxing dividends or limiting interest deductions," said John Harrington, a member of SNR Denton's tax practice. "To the extent the proposal suggests limiting interest deductions, it would have an impact."
But Harrington and others noted that the administration didn't offer a specific proposal for change, making discussion of any impact theoretical at best. For example, Harrington said that while the Obama plan suggests that debt gets less favorable treatment, it doesn't say how that would be implemented. A limit on maximum interest that can be deducted could offer very different results than a limit on all interest being deducted.
"A lot of specifics have to be developed," he said. "A limit on interest makes it more expensive to use debt, but it all depends on the details. At a certain level, interest might not be able to be used in highly leveraged transactions."
He said it's also possible that dealmaking could proceed as before but with a switch to more equity funding or with only slightly higher costs.
Tax expert Robert Willens said reduced interest reductions would have an impact beyond leveraged buyouts. It also would raise costs of companies' investing in their operations.
"If a company wants to build a plant and incurs debt to finance the construction, naturally it would increase the cost of doing that," he said.
The interest proposals were part of an overall corporate tax plan the administration floated that would create a 28% tax rate. The administration suggested that the tax code be reformed to quit picking winning and losing industries, which could result in higher taxes of companies that now pay lower rates of return. There was immediate response from potentially impacted sectors.
"We have serious concerns about any plan that pays for lower corporate tax rates by raising taxes on noncorporate businesses," said Steve Judge, president and CEO of the Private Equity Growth Capital Council. "We will work with Congress and the administration on this important issue to ensure that private equity and growth capital continues to foster economic growth."
Another of the suggested reforms in Wednesday's document was the elimination of preferential treatment of carried interest in private equity deals, and new minimum taxes for multinational companies' foreign earnings.
Secretary of the Treasury Timothy Geithner said Wednesday that he hopes to meet with a congressional committee soon to discuss the proposal, but Harrington said that it isn't likely the proposal would lead to immediate action in Congress.
"It's a menu of options. It looks more like a trial balloon than a specific proposal," he said. "I don't know how you could have more caveats.
"Tax reform is a long slog. It takes a high level buy-in. Does it mean it is more likely this year? I don't think it will accelerate anything this year," he said.
-- David Carey in New York contributed to this story.
Former Merrill Lynch & Co. executives have launched Andres Capital Management, managing U.S. fixed income portfolios. For other updates launch today's Movers & shakers slideshow.
Petstages is looking to secure a private equity sponsor after walking away from a deal with a strategic company because the company's management decided they would still like to own a stake in the company. More video