The Comprehensive Tax Gain From Leverage

Abstract

We expand the traditional specification of the tax gain from leverage by accounting for the choice between issuing debt and utilizing internal retained earnings equity. Standard analyses focus solely on the choice between debt and external equity. This results in the traditional tax gain from leverage, which equals the corporate tax benefit from debt minus the partially offsetting personal tax disadvantage. Expanding the debt analysis to include internal equity introduces a third tax component to the gain from leverage: a supplemental personal tax disadvantage. This supplemental disadvantage reflects the personal tax cost of distributing internally-generated equity to investors and using replacement debt. It reduces the overall or comprehensive tax gain from leverage and frequently converts it into a tax loss. Therefore, using debt often is costlier than generally assumed. We provide conceptual support for the comprehensive tax gain, plus some initial empirical support.

Keywords: gain from leverage, debt tax shield, pecking order, capital structure

JEL Classification: G32, H21, H24, H25, H32