Analytical and Empirical Evidence of the Effect of Tax Rates on the Trade-Off Between Debt and Managerial Ownership

Abstract

We show that, for a firm facing a high marginal tax rate, the benefit of using debt relative to managerial ownership to control agency costs increases at a decreasing rate. Debt and managerial stock ownership represent alternative mechanisms for reducing agency costs of the relationship between owner-investors and managers in firms. However, although debt and managerial ownership provide overlapping benefits, only debt can provide the differential benefit of reducing the firm's tax liability. While the tax benefit from using debt relative to managerial ownership to control agency conflicts is an increasing function of the firm's marginal tax rate, the decreased managerial ownership results in external investors bearing a larger part of the cost of debt that accrues to the firm. Effectively, for external investors, the cost of debt decreases at a decreasing rate when the marginal tax rate increases. Therefore, the trade-off between debt and managerial ownership predicted by the agency literature is expected to be strong at low marginal tax rates, but get progressively weaker at higher marginal tax rates. In this paper, we build an analytical model of this hypothesis and provide strong empirical evidence in its support. Our study contributes to a further understanding of how tax rates might affect the interaction of capital structure decisions with the incentive compatibility issues and corporate governance. The study also provides a basis for future studies to examine factors other than tax rates that differentially affect debt and managerial ownership costs.