Debt, Leases, Taxes and the Endogeneity of Corporate Tax Status

Abstract

We provide evidence that corporate tax status is endogenous to the financing decision, which induces a spurious relation between measures of financial policy and many commonly used tax variables. Specifically, both interest expense and lease payments are tax deductible. Thus, a firm that finances its operations with debt or leases reduces its taxable income, potentially lowering its tax rate. This endogeneity of the tax rate can bias an experiment in favor of finding a negative relation between leasing and taxes and against finding a positive relation between debt and taxes. We document that the endogeneity of the marginal tax rate is a very real problem that may confound the interpretation of tax-related effects in previous studies. We develop a direct measure of the corporate marginal tax rate that is based on taxable income before financing and therefore is not endogenously affected by financing decisions. Using this tax rate, and focusing on operating leases (which are likely to be true leases for tax purposes), we document a negative relation between operating leases and tax rates and a positive relation between debt levels and tax rates. Our leasing result is the first unambiguous evidence that low tax rate firms lease more than high tax rate firms, while the debt result helps resolve the capital structure puzzle. Previous research has shown that incremental debt financing decisions are positively related to tax rates; our result provides the first evidence linking debt levels to tax rates in a manner that is consistent with the theory.