As Certain as Debt and Taxes: Estimating the Tax Sensitivity of Leverage from State Tax Changes
European Central Bank (ECB)
New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); Research Institute of Industrial Economics (IFN)
August 6, 2014
AFA 2013 San Diego Meetings Paper
We use a natural experiment in the form of 121 staggered changes in corporate income tax rates across U.S. states to show that tax considerations are a first-order determinant of firms’ capital structure choices. Over the period 1990-2011, firms increase long-term leverage by around 40 basis points for every percentage point increase in the tax rate. Consistent with dynamic tradeoff theory, the tax sensitivity of leverage is asymmetric: firms do not reduce leverage in response to tax cuts. Using treatment reversals, we find this to be true even within-firm: tax increases that are later reversed nonetheless lead to permanent increases in a firm’s leverage. Our findings are robust to various confounds such as unobserved variation in local business conditions, union power, or unemployment risk. Treatment effects are heterogeneous and confirm the tax channel: tax sensitivity is greater among profitable and investment-grade firms which respectively have a greater marginal tax benefit and lower marginal cost of issuing debt.
Number of Pages in PDF File: 74
Keywords: Capital structure, debt policy, leverage, leverage dynamics, taxes, tradeoff theory, dynamic capital structure models, natural experiments
JEL Classification: G32working papers series
Date posted: March 18, 2012 ; Last revised: August 6, 2014
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