How to Broke the Dependence on Debt and Strengthen Firms: the DEBRA Proposal Against the Tax-induced Debt Bias

Abstract

Objective: This article assesses the impact of the debt-equity bias reduction allowance (DEBRA) proposal on the tax-induced debt bias. The tax-induced debt bias is present in most fiscal systems around the world that “subsidize” debt. Debt is more interesting than equity because its cost, the interest, is tax-deductible. As a result, firms tend to have more debt, which then generates negative externalities. To break this trend, the European Commission published a directive proposal comprising a DEBRA. Methods: The proposal includes both a notional deduction on growth in equity and an additional limitation on interest deduction for corporate income tax purposes. To evaluate the impact of the DEBRA proposal, Polish firms’ data from the BACH database over six years, from 2015 to 2020, are analyzed. Two criteria are analyzed: the impact on the ratio of total financial debt to net equity and on an Altman’s Z-score to estimate their solidity. Results: We observe that firms tend to keep a higher level of net equity and to reduce the level of debt. A stronger solidity of firms is also noted by a reduction in their likelihood of bankruptcy. Conclusion: The DEBRA should be an interesting fiscal tool in building an anti-fragility fiscal system. The proposal appears to be promising as it reinforces the stability of the firm in reducing the global level of its financial debt. Moreover, in improving the Z-score ratio, the DEBRA proposal tends to reduce the probability of firms going bankrupt.