Pouring oil on fire: interest deductibility and corporate debt
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Pouring oil on fire: interest deductibility and corporate debt Pietro Dallari1 · Nicolas End1 · Fedor Miryugin1 · Alexander F. Tieman1 · Seyed Reza Yousefi1
© Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract This paper investigates the role of tax incentives towards debt finance in the buildup of leverage in the nonfinancial corporate (NFC) sector, using a large firm-level dataset. We find that so-called debt bias is a significant driver of leverage, for both small and medium-sized enterprises and larger firms, with its effect accounting for up to a quarter of total leverage. These findings support the tradeoff theory of capital structure. We furthermore explore what firm traits affect these results, documenting how the strength of this effect differs with firm size, the availability of collateral, income and income volatility, cash flow, and capital intensity. We conclude that leveling the playing field between debt and equity finance through tax policy reform would decrease NFC leverage. Keywords Leverage · Debt Bias · Tax Policy · Corporate Income Tax · SMEs · Micro data JEL Classification H25 · H32 · D22 · G32
1 Introduction Tax bias towards debt finance is pervasive and affects leverage decisions. In most countries, the corporate income tax allows deduction of the interest paid on debt. Distribution of dividends, by contrast, is rarely deductible. The interest deduction is usually justified by a reference to the contractual obligation involved in a debt contract. Payments to equity holders do not involve such a contractual obligation and are hence considered optional. The deduction implies that debt financing is artificially cheaper than equity finance, distorting incentives and violating the principle of neutrality of the source of finance (e.g., Sorensen 2014; Weichenrieder and * Seyed Reza Yousefi [email protected] 1
International Monetary Fund, 1900 Pennsylvania Ave NW, Washington, DC 20431, USA
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Klautke 2008). Per the tradeoff theory of capital structure, a profit-maximizing firm will thus take on more debt than it would in absence of this incentive. This effect is labeled debt bias. High leverage lowers firms’ resilience to shocks. Leverage in the nonfinancial corporate (NFC) sector was already substantial before the global financial crisis (GFC) and has kept increasing, reaching 50% of GDP in some countries (Fig. 1). There is extensive evidence of debt bias for large firms and financial corporations. Until the 1990s, many economists were not convinced of the importance of the debt bias (Myers 1984). Over the last two decades, however, a significant number of studies have demonstrated the role of debt bias, mostly from a country-specific angle or for large multinational firms.1 One strand of research looks at debt bias in a single country. For instance, Graham et al. (1998), Graham (1999), and Gordon and Lee (2001, 2007) focus on US firms, while Barthody and Mateus (2005) and Dwenger and Steiner (2009) employ Portuguese and
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