Debt and Creative Destruction: Why Could Subsidizing Corporate Debt Be Optimal?
University of Chicago - Booth School of Business, and NBER
University of Chicago - Booth School of Business
July 12, 2012
Chicago Booth Research Paper No. 12-34
AFA 2013 San Diego Meetings Paper
Fama-Miller Working Paper
We illustrate the welfare benefit of tax subsidies to corporate debt financing. Two firms engage in a socially wasteful competition for survival in a declining industry. Firms differ on two dimensions: exogenous productivity and endogenously chosen amount of debt financing, resulting in a two dimensional war of attrition. Debt financing increases incentives to exit, which, while socially beneficial, is costly for the firm. Therefore the planner can increase welfare by subsidizing debt financing. The duration of industry distress determines the tradeoff between the welfare benefit illustrated in our model and the costs of subsidizing corporate debt from the existing literature. Our theory also sheds light on why the IRS considers "conflict of interest" as one of the key determinants in identifying securities that are qualified for tax-benefits.
Number of Pages in PDF File: 49
Keywords: War of Attrition with Asymmetric Information, Externality, Endogenous Types, Debt Tax Shield, Capital Structure, Tax Policyworking papers series
Date posted: March 17, 2012 ; Last revised: February 4, 2013
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