Have the Tax Benefits of Debt Been Overstated?

Abstract:     
We re-examine the “underleverage puzzle,” which argues many corporations fail to take full advantage of debt tax shields. We show that prior results suggesting underleverage stem from biased estimates of tax benefits from interest deductions. We develop improved estimates of marginal tax rates using a non-parametric procedure that produces largely unbiased estimates of the distribution of future taxable income. We show that additional debt would provide firms with much smaller tax benefits than previously thought, and when distress costs, non-debt tax shields, and the benefits of financial flexibility are also considered, it appears plausible that most firms have tax-efficient capital structures.

Keywords: capital structure, debt, marginal tax rates, corporate taxes

JEL Classifications: H20, M41, G31, G32

Working Paper Series