Collateral, Taxes, and Leverage

Abstract

We quantify the importance of collateral versus taxes for firms' capital structures. We estimate a dynamic contracting model in which a firm seeks financing and is subject to taxation. In the model, collateral constraints arise endogenously. Optimal leverage stays a safe distance from the constraint, balancing the tax benefit of debt with the cost of lost financial flexibility. Models with different tax rates fit the data equally well, and leverage responds to the tax rate only when taxes are low. We estimate the value of preserving financial flexibility at 7.2% of firm assets, which is comparable to the tax benefit.

Keywords: Collateral, Taxes, Leverage, Limited Commitment, Structural Estimation

JEL Classification: G32, G31, G35