Tax Deductibility Of Interest Payments Research Articles

The income bond puzzle

The income bond puzzle

Mortgage arrears, regulation and institutions: Cross-country evidence

Abstract Using a newly constructed database for 26 countries over 2000-2014, we analyze cross-country and within-country differences in mortgage arrears. We find that restrictive macro-prudential policies, in particular lower regulatory loan-to-value ratios, are significantly associated with a lower share of mortgage arrears in total residential debt. Likewise, better institutions are related with lower delinquency rates, both directly and by enhancing the impact of macro-prudential policies and the right to recourse. We also find that the effect of macro-prudential policies is conditioned by several mortgage market characteristics, such as the maturity of loans, interest rate fixity, and tax deductibility of interest payments.

Corporate income taxes, corporate debt, and household debt

We find that corporate income tax (CIT) rates are significantly positively associated with corporate debt and negatively associated with household debt, using panel data of 28 OECD countries between 1995 and 2015. The found association between CIT and debt comes from small countries where CIT is more exogenous due to tax competition. The tax deductibility of interest payments encourages firms to use more debt when CIT is high. If the total supply of loanable funds is not affected by a lower CIT, a lower CIT leads to a larger fraction of the total private debt incurred by the household sector. The estimated association becomes stronger in regressions with difference-stationary variables. A decrease in the CIT rate can explain around one-fourth of the increase in the average household debt incurred during the last two decades. The paper is the first study to investigate and yield supportive, though weak, evidence of distortion in household indebtedness caused by a CIT cut.

Mortgage Arrears, Regulation and Institutions: Cross-Country Evidence

Using a newly constructed database for 26 countries over 2000-2014, we analyze cross-country and within-country differences in mortgage arrears. We find that macro-prudential policies (notably regulatory LTV ratios) are significantly negatively associated with the share of mortgage arrears in total residential debt. Our results suggest that better institutions are also associated with lower delinquency rates, both directly and by enhancing the impact of macro-prudential policies and the right to recourse. Moreover, we find that the effect of macro-prudential policies is conditioned by several mortgage market characteristics, like the maturity of loans, interest rate fixity, and tax deductibility of interest payments.

Two Big Distortions: Bank Incentives for Debt Financing

Systemically important banks are subject to at least two departures from the neutrality of debt versus equity financing: the tax deductibility of interest payments and implicit funding subsidies. This paper fills a gap in the literature by comparing their mechanism and interaction within a common analytical framework. Findings indicate that both the tax shield and implicit funding subsidy remain large, in the order of up to 1 percent of GDP, despite decreases in recent years. But the underlying mechanisms differ. The tax shield incentivises debt financing as it reduces tax payments to the government. The implicit funding subsidy incentivises debt financing as it lowers private bankruptcy costs. This funding subsidy is passed on to other bank stakeholders. It therefore provides incentives for increases in balance sheet size and risk taking. This, in turn, increases the value of the tax shield. Overall, these results help to explain why systemically important banks are highly leveraged. JEL Classification: G21, G32, H25

A Theoretical Model for the Term Structure of Corporate Credit based on Competitive Advantage

We derive the term structure of corporate credit based on the competitive advantage of a firm and the tax deductibility of its interest payments. We consider the competitive advantage enjoyed by the firm as the central tenet of our model and capture its eventual demise in a probabilistic manner. We compensate the bond holder for expected losses and then provide an additional spread based on the tax deductibility of interest payments. Our simple intuitive model appears to overcome some of the well-known shortcomings of structural credit risk models.

Tax Deductibility of Interest Payments: Political Reasons for the Preferential Treatment of Debt in European Tax Systems

Most corporate tax systems in the world have in common that debt is treated favorably due to an allowance of interest deduction. This causes a so-called “debt bias” in modern tax systems. In literature the implications of this taxation habit are broadly discussed. The political dimension, however, has been hardly regarded. This work aims to make a contribution to fill this gap by identifying the political reasons of the maintenance of the deductibility of interest payments. I found that the Theory of Path Dependency as well as the Interest Group Theory might serve as explanation. By means of these theories a case study of Italy and the United Kingdom was conducted. In terms of the Interest Group Theory, I argue that family-owned businesses are a pressure group that aims at maintaining the tax advantage of debt. This group has the greatest ability to capture policymakers in countries that are prone to corruption and in which such a type of business is prevalent. Furthermore, I argue that the financial industry as another pressure group cannot unify their interests. Thus, in countries that have set their economic focus on financial services, policymakers are not captured and directed in a clear direction. As a result, slack-reducing crises that put pressure on a political system have a sharp effect on captured political systems. On the other side, the Theory of Path dependency provides a better explanation in the case of less captured countries. I argue that in those countries learning effects are triggered by exogenous shocks with a result of smooth adjustments of policy outcomes towards an efficient taxation system.

The Debt-Equity Tax Bias: Consequences and Solutions

The tax deductibility of interest payments in most corporate income tax systems coupled with no such measure for equity financing creates economic distortions and exacerbates leverage. This paper discusses the consequences of this debt bias and the possible remedies.JEL classification: H25, H32, G21, G32

Financial Leverage, Corporate Investment, and Stock Returns

This article rationalizes empirical patterns of market leverage, book leverage, book-to-market ratios, and stock returns across different book-to-market portfolios, using a model of firm financing and investment. The model analytically shows that tax deductibility of interest payments increases effective investment irreversibility and that investment irreversibility weakens the relation between book-to-market values and returns. This provides a clear and novel mechanism showing how financial leverage affects stock returns beyond the standard Modigliani-Miller paradigm. The article argues that market leverage, rather than operating leverage or investment irreversibility, explains a major portion of the value premium. Empirical evidence supports this argument.

OPTIMAL CREDIT RATINGS

In this paper, we show that an individual optimal credit rating exists for firms and empirically test whether firms strive to achieve their optimal rating. For this purpose, we consider the structural model by Leland [12], which balances the benefits of debt in the form of the tax-deductibility of interest payments against bankruptcy costs in order to obtain the optimal rating. Testable implications for both firms which have implemented their optimal rating and firms with non-optimal ratings are deduced. An empirical test with 420 firms contained in the S&P 500 Index indicates that all factors which theoretically drive optimal ratings also affect the observed rating in the predicted way. In line with our theory, observed ratings can be considerably better explained if, in addition to the traditional factors such as leverage and firm size, a proxy for bankruptcy costs and the default probability related to the optimal rating is considered. These findings suggest that U.S. firms contained in the S&P 500 Index strive to achieve their optimal credit ratings.

Taxation and the Financial Structure of Foreign Direct Investment

The vast increase in foreign assets globally has raised interest in how the home country should tax profits flowing from these investments. Broadly speaking, countries have chosen either to exempt foreign income from taxation or to subject foreign income to taxation with credits/deductions given for foreign taxes paid. Recent research has focused on the effect of these foreign income tax rules on the relationship between aggregate FDI flows and corporate tax rates. In this paper we examine how foreign income tax rules can affect the financial structure of subsidiary-level FDI in Europe. The tax-deductibility of interest payments suggests that higher (host-country) corporate tax rates should be associated with a greater proportion of debt-financed FDI, as foreign income tax credit systems should, in theory, limit the benefits of shielding foreign income from host country taxation. Our results indicate that whilst multinationals from tax exemption countries adjust the financial structure of foreign investments in response to corporate tax rates, the effect of corporate tax rates is insignificant for FDI originating from tax credit countries. These results reveal an additional channel through which foreign income tax credit systems attenuate the forces of tax competition.

THE ELUSIVE TAX GAIN ON DEBT

The now‐famous work of Modigliani and Miller (MM) (1) asserted that firms should prefer to use debt over equity in financing assets. That prescription holds that there exists realisable value in the tax deductibility of interest payments. The deductibility benefit lowers the cost of debt with attendant favourable reduction in the cost of capital. The effect translates into greater firm value for several reasons. First, the economic margin above capital cost increases. Second, more projects are good and can be undertaken by the firm allowing the garnering of increments of value. The conception is logical. The supporting theory is rigorous. However, a practical problem complicates matters. Namely, debt usage raises the possibility that firm earnings will not be sufficient to meet promised debt obligations. In this case the firm must declare itself bankrupt. Thus, debt is a two‐edged sword.

Bankruptcy Risk and Optimal Capital Structure

ABSTRACTThis study finds shortcomings in empirical tests of the capital structure irrelevance hypothesis. The alternative hypothesis is that firms choose value maximizing mixes of debt and equity on account of bankruptcy costs and the tax deductibility of interest payments. Based upon the cross‐sectional implications of the tax shelter‐bankruptcy cost hypothesis, an alternative test of the irrelevance hypothesis is performed. The test examines the relationship between failure rates and leverage ratios for 36 lines of business. The results are inconsistent with the irrelevance hypothesis.

Equal Access and Miller's Equilibrium

Controversy over the implications of debt and the rationale belying capital structure has seemingly come to rest upon a plateau defined by Miller's equilibrium analysis of aggregate corporate debt [10]. In “Debt and Taxes,” Miller reasserts his contention that whether capital is obtained through debt or equity has no bearing on the market value of the firm and is, therefore, irrelevant--a notion which has long been accepted with some reluctance by the finance academe. When the Modigliani-Miller model was first offered some 20 years ago [11], it was accompanied by a set of assumptions which portrayed the world of corporate finance in such malleable terms as to make the irrelevancy propositions palatable. Adaptation of this theoretical model (by its originators) to its secular counterpart through the imposition of corporate taxes [12] brought about a reassuring reversal of the irrelevancy doctrine, but left in its stead the disconcerting prescription to maximize firm value by financing exclusively via debt. Consideration of tax effects at the personal level by Farrar and Selwyn [7] marked the next concession to reality by capital structure theorists. Instead of alienating the original model still further from observed corporate behavior, this step provided a means of reconciling the overwhelming advantage of debt financing at the corporate level with the ultimate after-tax “consumption possibilities” afforded to individual investors. Miller's analysis explains that corporations are forced to “gross up” nominal interest rates to attract bondholders who must be compensated for their personal tax liability [10]. Potential increases in market value due to the taxdeductibility of interest payments are exhausted in the competitive drive toward equilibrium—at which point there are no gains from leverage. The sanctity of the irrelevance theorem thus appears to have been restored at the aggregate level.

Evidence on the Impact of Exchange Offers on Security Prices: The Case of Income Bonds

The question of whether the value of a firm is affected by its debt-equity ratio is still an unresolved one. In the Modigliani-Miller (1963) corporate tax model, the value of a firm is a positive function of its debt-equity ratio because of the tax deductibility of interest payments on debt financing. On the one hand, several authors (Kraus and Litzenberger 1973; Scott 1976; and Kim 1978) have shown that the introduction of bankruptcy costs in the Modigliani-Miller model implies that there will exist an optimum debtequity ratio for each firm and that the use of either more or less debt than the optimum amount will lead to a decrease in firm value. On the other hand, Miller (1977) has shown that, under certain circumstances, introduction of personal taxes implies that the value of an individual firm will be independent of its debt-equity ratio. The question ultimately is an empirical one. Masulis (1979) provides evidence on the question by examining the stock returns of firms that

Corporate Taxes and Capital Structure: Some Evidence Drawn from the British Experience

Both the traditional and Modigliani-Miller (hereafter referred to as M&M) versions of the theory of finance agree that a firm that takes advantage of the tax deductibility of interest payments can increase the value of its equity by levering its capital structure. Moreover, in the M&M view, the tax status of debt is the source of the only permanent benefit accruing to the firm from the use of leverage (Modigliani and Miller, 1958, 1963). Given the tax-deductibility of corporate interest payments the tax rate is directly related to capital structure: increases in the tax rate (other things being equal) leading to an increase in the debt-equity ratio. Despite the broad agreement among economists regarding the impact of taxes on leverage, the empirical evidence remains surprisingly incomplete and even inconsistent. Unlike the physical sciences, controlled experiments employing economic variables are a commodity in very short supply. And the tax impact on corporate financing decisions is no exception to this rule. Corporate tax rates, like a woman's age, do not change very often or by very much, at least in the short run. Hence, the degree of observed variation over a time period short enough to hold other effects reasonably stable is often too small to break through the wall of ubiquitous statistical noise. For example, in a comprehensive study of the determinants of U.S. firms' capital structures, Allan J. Taub (1975), in apparent contradiction to both the traditional and M&M views, found an inverse relationship between the tax rate and the use of debt. This perverse result undoubtedly reflects, as Taub has noted, the small degree of variation (4.8%) in the U.S. corporate tax rate during the period under study. This paper attempts to obviate the problem of inadequate variation by exploiting a major change in British corporate tax law, The Finance Act of 1965, which came into full effect in April 1966. By a fortuitous coincidence, accounting data for a large crosssection of British firms are available for both of the five year periods immediately before and after the change in the law, which permits a meaningful empirical measurement of the manner and degree to which taxes affect a firm's financial decisions.

Bankruptcy Costs and the Firm's Optimal Debt Capacity: A Positive Theory of Capital Structure

independent of its capital structure is a conceptual subject which continues to receive considerable attention and discussion in recent financial theory literature.1 The basic underlying premise of the M-M proposition is simply that in perfect securities markets, the capital structure decisions by firms belonging to the same risk class do not alter the opportunity set available to investors. Hence any discrepancies in total market values of identical firms in the same risk class arising from differences in financing mix will be removed through arbitrage operations by investors. But as recent financial writers point out, individual investors do not enjoy the limited liability priviledge accorded to firms, and more significantly, there are explicit costs to bankruptcy which may offset the advantage to the firm arising from the tax deductibility of interest payments. Hence the purpose of this paper is to examine in a formal manner, within the context of a mean-variance framework, if recognition of these securities market imperfections are sufficient to establish the traditional finance position that capital structure decisions have a significant impact on total firm value, and thereby provide the theoretical basis for a financial synergy rationale for conglomerate