Debt and Creative Destruction: Why Could Subsidizing Corporate Debt Be Optimal?
45 Pages Posted: 17 Mar 2012 Last revised: 13 Feb 2014
Date Written: July 1, 2013
We illustrate the welfare benefit of tax subsidies to corporate debt financing and study how the social cost/benefit trade-off of the subsidy changes with the duration of industry distress. To illustrate the benefit, we model two firms, which 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 costly for the firm, is socially beneficial. These benefits decline as industry distress shortens, and the planner trades them off with increased costs of subsidizing corporate debt from the existing literature. In practice, debt payments are only subsidized for profitable firms — this implementation arises naturally in our normative model, even though the goal of the policy is to entice low productivity firms to take on debt.
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