The Capital Structure Choice and the Consumption Tax

Abstract

1. Introduction Capital structure decisions are instrumental in everyday managerial finance (Stretcher and Johnson 2011). The principal theoretical narratives on the capital structure choice have focused on the importance of the taxes that burden the supplier of capital on personal or a corporate level (Miller and Modigliani 1961; Modigliani and Miller 1963; Miller 1977). However, the supplier of capital is not the only entity whose income is taxed. For every dollar of corporate sales, there may be a consumption on the consumer. Since this is not a on the investor, but a on the consumer, the consumption is considered to be an irrelevant topic in the capital structure debate, but only seemingly so: the consumption affects the quantity and the price of the goods that are sold and it thus affects corporate cash flows, capital budgeting and investment financing. This is the tax effect. Unless supply is perfectly elastic or demand is perfectly inelastic, the consumption ends up burdening not only the consumer but also the producer. Having been through the literature, there has not been any previous theoretical or empirical research to explore the effect of incidence and the consumption on leverage, yield spreads and agency conflicts between shareholders and creditors. In this direction, the following analysis demonstrates the negative effect of the incidence (on the producer) and the consumption on the investment and default thresholds, delaying entry and precipitating default. The incidence effect and the consumption are also shown to have a negative effect on yield spreads, agency cost of debt and the optimal leverage ratio. The impact of consumption and incidence on investment timing and financing naturally affects corporate revenues and therefore government revenue from consumption and income taxes. In this model, government revenue is studied in a real options framework and optimal policies are estimated, calculating the level of the consumption that maximizes expected government revenue from taxation. The numerical results of this analysis provide us with a new approach to the Ramsey rule on consumption taxes, associating policies with optimal rules of irreversible investment under uncertainty. We proceed with a brief literature review on the association between corporate debt and taxes. Section 3 sets up a theoretical model for our capital budgeting problem of irreversible investment. Section 4 presents numerical results on the effects of the consumption on investment timing, agency costs of debt, yield spreads and optimal leverage. Section 5 calculates expected government revenues from taxes and suggests revenue maximizing policies, based on the effect of the consumption on investment timing and financing. The final section concludes the paper. 2. An Outline of the Debt-and-Narrative Trading shields of corporate debt for bankruptcy costs: this is the main platform of the real options approach to the interaction between operating and financing decisions. Of course, this modeling idea is not fundamentally a real-options one. Laying the foundations of modern microeconomic thought on corporate finance, Miller and Modigliani (1961) and Modigliani and Miller (1963) showed that a firm could actually increase its value without affecting its operating income, implementing an appropriate choice of the capital structure mix. The optimal magnitude of debt financing depends on the effects of the shields of corporate debt and the costs of financial distress. In this framework, it is the rate on corporate income that drives the capital structure choice. This theoretical result has generated significant implications for the theory and practice of corporate finance and there has been empirical evidence to show a positive effect of corporate income on the extent of debt financing (e. …