Government policies and corporate financing decisions in China: Theory and evidence

Abstract

This paper examines the effect of government policies on the financing decisions of firms in China. A real options model is developed to understand how fiscal and monetary policies affect corporate leverage. The model predictions will be tested with a comprehensive panel data set spanning from 2002 to 2011. This work documents robust evidence that show the positive association of both tax and risk-free rate with firm leverage: increase in tax rate and risk free rate by one standard deviation results in the increase in corporate leverages by 0.61 to 1.06 percent and 2.54 to 3.68 percent, respectively. In addition, the productions of the firms are not affected by the tax rate in the short run, and the firms are operating in their optimal market leverage. The implied tax rate and risk free rate are solved by assuming that the firms achieve their optimal leverages. The implied tax rate declines with the size, whereas the opposite goes for implied risk-free rate.