Corporate Taxes and Capital Structure: Some Evidence Drawn from the British Experience

Abstract

Both the traditional and Modigliani-Miller (hereafter referred to as M&M) versions of the theory of finance agree that a firm that takes advantage of the tax deductibility of interest payments can increase the value of its equity by levering its capital structure. Moreover, in the M&M view, the tax status of debt is the source of the only permanent benefit accruing to the firm from the use of leverage (Modigliani and Miller, 1958, 1963). Given the tax-deductibility of corporate interest payments the tax rate is directly related to capital structure: increases in the tax rate (other things being equal) leading to an increase in the debt-equity ratio. Despite the broad agreement among economists regarding the impact of taxes on leverage, the empirical evidence remains surprisingly incomplete and even inconsistent. Unlike the physical sciences, controlled experiments employing economic variables are a commodity in very short supply. And the tax impact on corporate financing decisions is no exception to this rule. Corporate tax rates, like a woman's age, do not change very often or by very much, at least in the short run. Hence, the degree of observed variation over a time period short enough to hold other effects reasonably stable is often too small to break through the wall of ubiquitous statistical noise. For example, in a comprehensive study of the determinants of U.S. firms' capital structures, Allan J. Taub (1975), in apparent contradiction to both the traditional and M&M views, found an inverse relationship between the tax rate and the use of debt. This perverse result undoubtedly reflects, as Taub has noted, the small degree of variation (4.8%) in the U.S. corporate tax rate during the period under study. This paper attempts to obviate the problem of inadequate variation by exploiting a major change in British corporate tax law, The Finance Act of 1965, which came into full effect in April 1966. By a fortuitous coincidence, accounting data for a large crosssection of British firms are available for both of the five year periods immediately before and after the change in the law, which permits a meaningful empirical measurement of the manner and degree to which taxes affect a firm's financial decisions.