Abstract
We re-examine the relation between taxes and corporate leverage, using variation in state corporate income tax rates. In contrast with prior research, we document that corporate leverage increases following tax cuts for both privately held and publicly listed firms. We use an estimated dynamic equilibrium model to show that tax cuts result in lower default spreads and more distant default thresholds. These effects outweigh the loss of benefits from the interest tax deduction and lead to higher leverage, especially for privately held firms. Overall, debt tax shields appear to be a secondary capital structure consideration.
Highlights
We revisit an old question that has been at the center of corporate finance at least since Modigliani and Miller (1963): the effect of corporate taxes on business borrowing
We first test how corporate leverage is related to state corporate income tax cuts, utilizing the sample of private firms spanning 2011–2017 and data on state corporate income tax cuts from 2007 through 2019
Using comprehensive samples of both private and public companies and relying on simple event study techniques in the spirit of Borusyak and Jaravel (2017), we study the evolution of corporate borrowing around changes in state corporate income taxes since the 1980s
Summary
We revisit an old question that has been at the center of corporate finance at least since Modigliani and Miller (1963): the effect of corporate taxes on business borrowing. A higher tax rate exerts downward pressure on optimal debt because credit spreads rise, as both default thresholds and lender recovery fall in default Ex ante, it is not clear which of these effects is quantitatively more important, but our estimation results indicate that the negative effects of taxes on leverage are an order of magnitude more important than the positive effects, but only in those states of the world in which debt is risky. Large firms are less productive, so they do not need to use debt to fund capital expenditures They keep their leverage in a region in which it is effectively fully collateralized, so the interest tax deduction is all that matters.
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