Effects of Tax Policy on Corporate Financing Decisions: Integration of the Corporate and Personal Income Tax

October 1, 1994

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Special Academic Paper

Executive Summary In January, 1992, the United States Department of Treasury released its report, Integration of the Individual and Corporate Tax Systems: Taxing Business Income. Only once, recommending that the U.S. adopt an integrated tax system to eliminate double taxation of corporate profits. In December of that same year, the American Institute of Certified Public Accountants joined the Treasury in advocating the adoption of integration. In each case, one of the goals of integration was to reduce the economic distortion of the existing classical corporate and personal income tax systems in favor of debt financing over equity financing of corporate investment. A second bias that integration was intended to alleviate was the tax-incentive for corporations to retain earnings.

This study examines whether the adoption of an integrated tax system in New Zealand, Canada, and Australia altered corporate financing decisions. In each case, the country had previously used a classical tax system similar to that employed in the U.S., and in each case the country integrated its corporate and personal income taxes so as to eliminate the double taxation of corporate earnings.

This study examines a group of firms in each country before and after the country integrated its tax system. By looking at the same firms over the period of the change it is possible to distinguish the effect of the change in tax law on corporate financing decisions from many of the myriad of other influences affecting these decisions.

The two key decisions with which this study deals are the choice of equity versus debt financing and the level of retained earnings of firms in these countries. The classical tax system creates a bias in favor of debt financing over new-issue equity that arises through the deductibility of interest expense at the corporate level while dividend distributions remain non – deductible.

A classical income tax system can also create an incentive for corporations to retain more earnings than they would if no corporate income tax were imposed. The incentive to retain earnings arises because dividend distributions are subject to individual income tax. Alternatively, retained earnings produce capital gains which may be offset by capital losses from other sources, may be subject to a preferential rate of tax, or may be deferred until death at which time they may be excluded from tax through the estate tax exclusion.

In New Zealand, integration was adopted without any change in the taxation of capital gains. In Australia and Canada, a capital gains tax on realized stock gains was adopted at the same time integration was adopted. The results of this study support the assertion that adoption of an integrated tax system reduces corporate financial leverage. Evidence from both New Zealand and Canada indicate that tax integration is a significant determinant of corporate capital structure and contributed to decreased levels of financial leverage.

In Australia, no link could be established between the adoption of integration and the debt-to-equity ratios of domestic firms. In New Zealand, where no significant change was made in the taxation of capital gains, the average debt-to-equity ratio of the firms studied fell from 2 .69 prior to integration to 1 .40 after integration, so that corporate leverage was 56 percent lower after integration than it would have otherwise been.

In Canada, the effects of integration were intermingled with reactions to the introduction of capital gains taxes. Since the average firm should react to both changes, the study concentrated on firms believed to be affected by only one or the other of the changes. In response to the new capital gains tax, it was expected that high growth firms (those most likely to retain earnings to finance additional investment) would increase their debt. The results indicate that high-growth Canadian firms had debt-to-equity ratios which were 21 percent higher than expected in the absence of integration and capital gains.

These results contrast sharply with Canada’s high-dividend firms. These firms, which were most influenced by integration, reported debt-to-equity ratios 25 percent lower than predicted in the absence of integration and capital gains. These results support the findings with respect to New Zealand and extend the research by confirming that the “benefits” of tax integration may be offset by changes in capital gains taxes. These results also indicate that firms should not be considered homogeneous in their reactions to tax policy changes.

In Australia, no sample or sub-sample reacted as expected to the passage of integration. The two portfolios of interest, high growth and high dividend firms, experienced no significant change in leverage in response to either tax integration or capital gains taxes. If Australian firms reacted to integration by reducing leverage, it was apparently offset by other tax changes, including the capital gains tax increase.

As the differences between Canada and Australia show, one must use caution in generalizing the results of this study to other countries. Graham and Bromson (1992) determined that there exist significant country-specific influences on corporate leverage. Such country-specific influences, believed to arise from differing state-finance-industry relationships, probably explain much of the observed difference between average debt-to-equity ratios of the samples in the three countries both before and after integration. Furthermore, the adoption of integration in any country may differ by a multitude of factors such as time, political climate, and economic environment.

Despite these limitations, the findings in this paper provide empirical support for the argument that integrating the corporate and personal income taxes can reduce corporate financial leverage. The findings also indicate that this favorable effect is diminished by increased taxes on gains realized through stock appreciation. These are important conclusions for the United States, which is considering both integration and the reintroduction of preferential tax treatment of capital gains.


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