Do Personal Taxes Affect Capital Structure: Evidence from the 2003 Tax Cut

45 Pages Posted: 14 Mar 2012 Last revised: 29 Sep 2014

See all articles by Leming Lin

Leming Lin

University of Pittsburgh - Katz Graduate School of Business

Mark J. Flannery

University of Florida - Department of Finance, Insurance and Real Estate

Date Written: February 29, 2012

Abstract

Because the personal tax treatments of interest and dividend income likely affect the relative cost of debt and equity financing, a sharp change in tax treatment could affect firms' optimal leverage. This paper examines the effect of the 2003 equity income tax cut on firms' debt usage. Because this tax cut affected only individual investors, we can use a difference-in-differences method to identify the effect of personal tax on firms' leverage. Previous research has found that the 2003 tax cut encouraged dividend payouts and reduced the cost of equity, but it provides no link to equilibrium leverage ratios. We estimate that the tax cut causes the affected firms' leverage to decrease by about 5 percentage points. Furthermore, we show that the effects of the tax cut are stronger for firms with lower marginal corporate tax rates and for firms that are not financially constrained, consistent with our theoretical predictions. Overall, we find strong evidence that personal tax is an important determinant of firms' optimal leverage.

Keywords: Capital structure, Personal taxes, Individual ownership

JEL Classification: G32

Suggested Citation

Lin, Leming and Flannery, Mark Jeffrey, Do Personal Taxes Affect Capital Structure: Evidence from the 2003 Tax Cut (February 29, 2012). Journal of Financial Economics (JFE), 2013, 109, 549-565. Available at SSRN: https://ssrn.com/abstract=2021333 or http://dx.doi.org/10.2139/ssrn.2021333

Leming Lin (Contact Author)

University of Pittsburgh - Katz Graduate School of Business ( email )

346 Mervis Hall
University of Pittsburgh
Pittsburgh, PA 15260
United States

Mark Jeffrey Flannery

University of Florida - Department of Finance, Insurance and Real Estate ( email )

P.O. Box 117168
Gainesville, FL 32611
United States
352-392-3184 (Phone)
352-392-0103 (Fax)

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