Optimal Debt Bias in Corporate Income Taxation

23 Pages Posted: 18 Nov 2015

See all articles by Jenny Simon

Jenny Simon

Stockholm Institute of Transition Economics

Multiple version iconThere are 2 versions of this paper

Date Written: October 20, 2015


I present a rationale for a government to discriminate between debt and equity financing when taxing corporate income. For risk-averse entrepreneurs, equity generates more surplus than debt, because it provides financing and insurance. A government seeking to extract surplus from entrepreneurs would naturally tax equity-generated income more than debt-generated income. I also establish a less obvious reason why the government might want to extract surplus from entrepreneurs. It is well understood that when the quality of projects is unobservable to investors, risk-averse entrepreneurs with higher-return projects might retain a larger share of equity to signal their type (Leland and Pyle (1977)). I show that in such an adverse selection setting, while competitive investors are constrained to offer actuarially fair terms, the government can use taxes to discriminate between types. This degree of freedom allows manipulation of the relevant incentive constraints so that a lower level of debt suffices for separation, and an increase in overall efficiency can be obtained. Since entrepreneurs separate along their debt-to-equity ratios, the optimal non-linear tax schedule to achieve the desired discrimination is isomorphic to one that taxes debt-generated income at a lower rate than equity-generated income.

Keywords: corporate taxation, debt bias, investment decision under asymmetric information

JEL Classification: G180, G110, H250, D820

Suggested Citation

Simon, Jenny, Optimal Debt Bias in Corporate Income Taxation (October 20, 2015). CESifo Working Paper Series No. 5561, Available at SSRN: https://ssrn.com/abstract=2691961 or http://dx.doi.org/10.2139/ssrn.2691961

Jenny Simon (Contact Author)

Stockholm Institute of Transition Economics ( email )

Sveavägen 65
Stockholm, 11383

HOME PAGE: http://www.jennysimon.net

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