How did the notional interest deduction affect Belgian SMEs’ capital structure?

Abstract

The recently introduced risk capital allowance in Belgium, which allows a notional interest deduction (to be denoted NID hereafter) on a firm’s adjusted equity for tax purposes, has mitigated the tax discrepancy between equity and debt financing. To our knowledge, we provide the first empirical study of the extent to which this regulation has resulted in a strengthening of small and medium sized enterprises’ (to be denoted SMEs hereafter) solvency, which was one of its most prominent objectives. Results from logit regressions reveal that the probability of adopting the NID is higher for lowly leveraged SMEs, SMEs without experience with the tax-exempt investment reserve and SMEs with a sound knowledge of the notional interest deduction regulation. Results on the impact of the NID on the capital structure of SMEs based on panel and first differences regressions reveal that this measure did not result in a significant change of SMEs’ leverage. In view of the discussion regarding the optimal tax and legislative framework that governments should put in place (Poutziouris et al., J Small Bus Enterp Dev 6(1):7–25, 1999), these results cast doubt on the risk capital allowance, as it stands now, being the right government instrument to contribute—at least in the short term—to creating a pro-enterprising tax and legislative climate for SMEs. We conclude by providing some general suggestions for improving the effectiveness of the risk capital allowance.