How Tax Hypothesis Determines Debt Maturity in Indian Corporate Sector

Abstract

Trade-off theory states that the optimum debt maturity is determined by a dynamic trade-off between the tax advantages of debt and deadweight cost of bankruptcy as the firms recapitalize with debt depending upon the term structure of interest rate and asset volatility. Therefore, the corporate tax rate, term structure, and asset variance jointly determine corporate debt maturity. This paper empirically examines how the tax hypothesis determines debt maturity in the Indian corporate sector using a panel data of 266 companies drawn from BSE 500 for the period 2000-2010. Our research findings unequivocally establishes that the tax rate, term structure and asset variance profoundly influence the debt maturity structure in Indian corporate sector. The statistically significant and negative coefficient on tax rate clearly indicates that optimal debt maturity is determined by the trade-off between the tax benefits of debt against the cost associated with financial distress and bankruptcy risk. The coefficient on term structure shows that in the periods of declining term structure and higher corporate tax rate, the firms maximize market value by increasing the proportion of short-term debt in the capital structure. The statistically significant but positive regression coefficient on asset variance rejects the tax hypothesis that debt maturity is inversely related to asset variance. The complex tax regime, high rate of corporate tax and dysfunctional corporate bond market have adversely affected the growth and development of the business and industry. Therefore, comprehensive reforms are required in tax code, and initiatives are to be taken for developing the corporate bond market by introducing diverse products, which can provide avenues for financing, investment, and risk diversification.