How Does a Cap on Interest Expense Change the Tax Benefits of Debt?

Abstract

Using a production-based structural model, calibrated with U.S. data for the period 2001-2017, we find that for the typical firm an EBIT-based cap on the deduction of interest reduces the tax benefits of debt by 1% of unlevered firm value. This impact differs across industries ranging from a decline of 0.3% to 3.7% of unlevered firm value. Industry specific capital to labor ratio is a key driver of these effects. A typical firm’s marginal tax benefit declines from 14.3% to 7.8% of unlevered firm value. An EBITDA-based cap reduces the differential impact across industries.

Keywords: Tax Cuts and Jobs Act, Tax Benefits

JEL Classification: G1, G32, G33