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The Impact of Federal Taxes on the Use of Debt by Closely-Held Corporations

1 min readBy: C. Bryan Cloyd, Stephen T. Limberg, John R. Robinson

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Special Academic Paper

Executive Summary It is often asserted that the income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. encourages the use of debt because of the deductibility of interest expense. We examine this conjecture by analyzing the interest incurred by a large sample of closely-held corporations. We estimate regressions of the level of interest on the estimated marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. , the level of non-debt tax shields, a term reflecting the interaction of tax rates with non-debt tax shields, and other determinants of leverage. The evidence is consistent with the assertion that the tax benefits associated with interest expense encourage firms to use debt. We also find evidence that the extent to which tax rates influence firms to incur interest expense depends significantly on the availability of other non-debt tax shields.