Debt financing, the Darby Effect, and the inflation-induced penalty in historical cost depreciation

Abstract

Maher and Nantell (1983, p. 335) have argued that, given Miller's (1977, p. 269) equilibrium tax rates, debt financing aggravates the tax penalty imposed on a firm which employs tax-law mandated historical cost depreciation in an inflationary environment. This contrasts with conventional wisdom which argues that debt financing ameliorates the tax penalty. This issue is of considerable public policy importance as the conventional argument against inflation-adjusting depreciation allowances is precisely the ameliorating effect of debt financing, to wit, firms can neutralize the taxpenalty by suitably adjusting their capital structures. Other research critical of theMaher-Nantell conclusion has focused on their assumption that Miller's equilibrium tax rates (1977, p. 269) obtain. This paper shows that the Maher-Nantell (1983, p. 335) result depends critically on their implicit assumption that the Darby Effect (Darby 1975, p. 272) holds. Both empirical evidence and a theoretical argument are cited which contradict the Darby Effect. The behavior of the interest rate on the firm's debt is modelled to accord with the empirical evidence. It is shown that in certain situations conventional wisdom regarding the ameliorating effect of debt financing on the firm's tax penalty is upheld whether or not Miller's equilibrium tax rates obtain.