Taxes, Investment, and Capital Structure: A Study of U.S. Firms in the Early 1900s

Abstract

We analyze capital structure decisions of U.S. firms during 1905-1924, a period characterized by two shocks that provide a unique experiment for studying the primary determinants of financing choices: (i) the introduction of corporate and individual taxes, and (ii) the onset of World War I, which resulted in large, transitory increases in investment outlays by U.S. firms. Although we find little evidence that shocks to corporate and individual taxes have a meaningful influence on observed leverage ratios, we find strong evidence that changes in leverage are positively related to investment outlays and negatively related to operating cash flows. Moreover, the transitory investments made by firms during World War I are associated with transitory increases in debt, especially by firms with relatively low earnings. We conclude that our findings are inconsistent with models that emphasize taxes as a first-order determinant of leverage choices, but broadly consistent with models that link the dynamics of leverage with dynamics of investment opportunities.

Keywords: capital structure, taxes, investment

JEL Classification: G3, G32