Abstract
Tbis paper presents a model of corporate financial policy in a growing economy and then uses this model to study the effects of changes in corporate and personal taxes. Our picture of the firm includes a flexible debt-equity ratio and a flexible dividend payout rate. The costs to the firm of both debt and equity capital are increasing functions of the firm's debt-equity ratio. We use a realistic description of the tax system that includes a corporate income tax with deductible interest expenses, a personal income tax, and a favorable tax treatment of retained earnings. Our work builds on earlier research^ on both corporate finance and taxation but provides a more general and realistic model. This new model implies a unique optimal debt-equity ratio instead of the indeterminacy associated with the Modigliani-Miller tradition. The model also implies that firms will choose a positive equilibrium payout rate in spite of the favorable taxation of retained earnings. We know of no other model that explains why firms simultaneously borrow and pay dividends in an economy witb corporate and personal taxation. The model is presented and explained in Section I. The second and third sections then examine the effects of changes in the corporate tax rate and in the differential between the taxation of dividends and of retained earnings. The nonneutrality of the corporation tax is discussed more generally in Section IV.
Highlights
To avoid the usual complexities and ambiguities of corporate tax shifting in a two-sector model, we assume that all business activity takes a corporate form
We show that when firms combine debt and equity finance, the introduction of a corporation tax with full interest deductibility reduces the net yield to bondholders
To summarize in economic terms, the constancy of iN results from the fact that the cost-of-capital equation and the cash flow equation both embody eN, x, and ix in precisely the same functional form. Viewed in this way the result is no surprise at all. These equilibrium relations are concerned with firms' behavior and as such depend only on the returns to capital gross of personal taxation; in particular, the tax on retained earnings enters only through e, which is fixed in steady-state equilibrium
Summary
In order to study these questions, we extend the simple onesector, nonmonetary growth model to include a specification of the financial behavior of firms and households. Debt costs the firm i per unit of capital raised, and this return is taxed at the personal interest income rate d. Since p is not an argument of 0 or \}/, the policy p = 0 would seem always to be the best The answer to this line of argument is that if all earnings were retained, the equity of the firm would grow at a rate equal to the rate of return on equity gross of personal income tax. Equations (1.13) and (1.15) describe the first-order conditions for the firm's problem of selecting a debt proportion b and a payout ratio p that minimizes the cost of capital subject to the firm's equity growth constraint.^
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