Taxation and the Optimal Constraint on Corporate Debt Finance
40 Pages Posted: 19 Dec 2014
Date Written: December 18, 2014
The tax bias in favour of debt finance under the corporate income tax means that corporate debt ratios exceed the socially optimal level. This creates a rationale for thin-capitalization rules limiting the amount of debt that qualifies for interest deductibility. This paper sets up a model of corporate finance and investment in a small open economy to quantify the deadweight loss from the asymmetric tax treatment of debt and equity and to identify the second-best optimal debt-asset ratio in the corporate sector. For plausible parameter values derived from data for the Norwegian economy, the deadweight loss from the tax distortions to corporate financing decisions amounts to 2-3 percent of total corporate tax revenue, and the socially optimal debt-asset ratio is 4-5 percentage points below the debt level currently observed. Driving the actual debt ratio down to this level would generate a total welfare gain of about 3 percent of corporate tax revenue. The welfare gain would arise partly from a fall in the social risks associated with corporate investment, and partly from the cut in the corporate tax rate made possible by a broader corporate tax base.
Keywords: thin capitalization rules, tax bias against equity finance
JEL Classification: H210
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