The Economic Recovery Tax Act of 1981 and Corporate Capital Structure

Abstract

N Miller [11] includes personal and corporate taxes but not nondebt tax shields in his model of the firms' capital structure decision. On the contrary, DeAngelo and Masulis [6] incorporate personal and corporate taxes as well as nondebt tax shields, such as depreciation and investment tax credits, into their model, and they find that an optimal capital structure exists at the firm level. A central testable hypothesis of the DeAngelo and Masulis model, hereafter referred to as their tax shield hypothesis, is that a ceteris paribus decrease (increase) in a firm's nondebt tax shields results in an increase (decrease) in the optimal amount of debt that the firm employs. The DeAngelo-Masulis tax shield hypothesis is tested by Bowen, Daley, and Huber [3], Bradley, Jarrell, and Kim [4], Boquist and Moore [2], and Titman and Wessels [16]; the results are not supportive of the hypothesis. For several reasons, the results of existing empirical studies do not necessarily refute DeAngelo and Masulis' hypothesis of a negative relationship between the levels of nondebt tax shields and leverage at the firm level. First, the DeAngelo-Masulis tax shield hypothesis only holds, ceteris paribus, at the firm level. DeAngelo and Masulis hypothesize that, other factors held constant, a firm which experiences a reduction in nondebt tax shields will increase its usage of debt financing. This does not imply a negative relationship between the levels of leverage and nondebt tax shields across firms, unless those firms are identical in all respects except for their levels of leverage and nondebt tax shields. Thus, there is the possibility of an omitted variables problem in a cross-sectional study of the relationship between the levels of nondebt tax shields and leverage, because other firm-specific factors besides nondebt tax shields determine leverage ratios. For instance, Myers [12] hypothesizes that the agency costs The author thanks three anonymous referees and the participants in the 1989 Eastern Finance Association Meetings for helpful comments on earlier drafts of this paper.