Taxes Depress Corporate Borrowing: Evidence from Private Firms

Abstract

We re-examine the relation between taxes and corporate leverage, using variation in state corporate income tax rates. In contrast with prior research, we document that corporate leverage rises after tax cuts, mostly for small private firms, but to a lesser extent for public firms. We use an estimated dynamic equilibrium model to show that tax cuts result in more distant default thresholds and thus lower credit spreads. These effects outweigh the loss of the interest tax deduction and lead to higher optimal leverage choices, especially for firms with stringent default conditions, such as the small private firms we study.

Keywords: corporate income taxes, leverage, investment, structural estimation

JEL Classification: G32, G31