The Economy-Wide Gains from Resolving Debt Overhang

Abstract

This paper develops a heterogeneous firm general equilibrium model with endogenous innovation and default to assess policies related to leverage and debt overhang. We estimate key model parameters and find that near default, debt overhang induces nonlinearities in firm innovation decisions leading to slower growth from incumbent firms. However, debt overhang induces firms to take on less leverage ex ante and partially offsets inefficiencies stemming from the monopoly markup and taxation’s effect on entry. In the context of these tradeoffs, the general equilibrium gains from resolving debt overhang are negative, with implications for assessing the gains from corporate tax policies.

Keywords: Debt Overhang, Default, Innovation, Growth

JEL Classification: E22; G33; H25