The Capital Structure Choice and the Consumption Tax

Abstract

The consumption tax is imposed on the consumer, but it also affects the wealth of the producer because of the tax incidence effect: depending on supply and demand elasticity, the consumption tax reduces the market clearing price. Therefore it affects cash flows from corporate investment and becomes a significant factor for capital budgeting choices on investment timing and financing and the respective conflicts of interest between shareholders and creditors. This paper employs a real option model to explore the impact of the consumption tax and tax incidence on corporate valuation: the consumption tax delays investment and precipitates default, because the tax incidence on the producer makes the investment less attractive. Furthermore, we find that the consumption tax has a negative effect on the agency costs of debt, the yield spreads and the optimal leverage ratio. Finally, the model also produces implications for governmental tax policy, suggesting the magnitude of the consumption tax that maximizes expected government tax revenue.