High Corporate Taxes May Increase Debt, Study Finds
February 11, 2016
A new paper published in the Journal of Financial Economics finds that countries with high tax rates on corporate income also have higher corporate leverage ratios. This paper improves upon the methodologies of prior research that had struggled to confirm a link between tax rates and corporate structure.
Economic theory predicts that businesses measure the benefits of raising capital from lenders against the costs of having these fixed obligations. In the U.S., interest paid on corporate debt is tax deductible, whereas payments to equity holders are not. In the United States, equity is taxed at 39% at the corporate level and then taxed again at the individual level when it is distributed to shareholders. Since the U.S. currently has one of the highest corporate tax rates in the world and interest on debt receives preferential tax treatment, one should expect U.S. firms to have significant leverage.
Unfortunately, such effects have proven difficult to parse from the available data. Consolidated financial statements constrain the ability of researchers to isolate the tax jurisdictions where income is earned. Most research assumes that either all of a business’s income is earned in the United States or repatriated from countries in which it operates. However, if a business retains its income in foreign affiliates where tax rates are lower, this will reduce the benefits of adding debt to a business’s capital structure. This would, in effect, understate the true impact of corporate taxes on leverage.
Using survey data of multinational corporations from the Bureau of Economic Analysis (BEA), the authors are able to overcome this shortcoming in the empirical literature. They find that businesses that report their income in high tax jurisdictions have corporate leverage ratios that are substantially higher than those in low tax jurisdictions. More precisely, they find that a business facing an average tax rate of 35% has a leverage ratio that is 7.1% higher than a similar firm facing an average tax rate of 25%.
The authors carefully note that their methodology only permits them to detect a correlation between tax rates and leverage, not a causal relationship. They concede that firms may be choosing their operating location based on their financial structure, rather than adapting their financial structure to a country’s tax system. Nonetheless, this paper provides a new avenue for future research and strengthens the case for corporate tax reform.