Taxes, Limited Liability and Leverage

31 Pages Posted: 27 Oct 2012 Last revised: 17 Feb 2013

See all articles by Erich Pummerer

Erich Pummerer

University of Innsbruck - Department of Accounting, Auditing and Taxation

Marcel Steller

University of Innsbruck - Department of Accounting, Auditing and Taxation

Date Written: October 26, 2012

Abstract

We discuss the combined effects of tax convexity, limited liability and leverage on risk-taking. First, we focus on a risk-averse investor who is indifferent to equity-finance a risky asset in a pre-tax setting. We derive the after-tax marginal prices for risk-averse investors. Symmetric taxation causes an increase in marginal prices, while convex taxation causes a decrease. The negative effects of tax convexity can be overcome by debt-financing a risky project in the case of limited liability for the debtor. We develop explicit solutions for optimal leverage and show that tax convexity is a sufficient condition for a high degree of leverage. In contrast to previous literature, we explain why increasing tax-convexity will increase leverage. Second, we solve for the coefficient of risk-aversion, making a creditor indifferent to supplying the required debt-financing contract. The results indicate that analyzing tax effects separating investment and financing decisions is not useful in case of tax convexity.

Keywords: tax convexity, risk-taking, optimal leverage, limited liability, loss-offset

JEL Classification: M25, M41

Suggested Citation

Pummerer, Erich and Steller, Marcel, Taxes, Limited Liability and Leverage (October 26, 2012). WU International Taxation Research Paper Series No. 2012-02, Available at SSRN: https://ssrn.com/abstract=2167386 or http://dx.doi.org/10.2139/ssrn.2167386

Erich Pummerer (Contact Author)

University of Innsbruck - Department of Accounting, Auditing and Taxation ( email )

Universitätsstraße 15
Innsbruck, Innsbruck 6020
Austria
+43/512/507-7264 (Phone)

HOME PAGE: http://www.pummerer.at

Marcel Steller

University of Innsbruck - Department of Accounting, Auditing and Taxation ( email )

Universitätsstraße 15
Innsbruck, Innsbruck 6020
Austria

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