Debt Bias in Corporate Income Taxation and the Costs of Banking Crises

Abstract

Corporate income taxation (CIT) in most countries favors debt over equity financing, leading to over-indebtedness. This problem is particularly acute for the financial sector. We estimate financial-stability benefits of eliminating this debt bias. We estimate the long-run effects of CIT on bank leverage and, using a Vasicek-based model of banking crisis losses, we find that eliminating this debt bias could reduce public finance losses in the range of 30 to 70%. These results hold even for conservative estimates of bank-leverage and portfolio-risk effects of CIT changes.

Keywords: capital structure, debt bias, public finance, systemic risk, taxation

JEL Classification: G01, G28, G32, H25