Does the Tax Deductibility of Interest Affect Financial Reporting?

Abstract

Many countries have imposed tax policies that limit the deductibility of interest costs, creating a plausibly exogenous increase in the net cost of borrowing. The limits are based on financial accounting numbers, adding a new incentive into managers’ choices. Firms in these countries are also expected to rely less on debt financing and face weaker demand for conservative financial reporting from creditors as compared to firms in other countries. Tests employ a large sample of U.S. firms around the implementation of interest limits under the Tax Cuts and Jobs Act, and a second set of firms in OECD countries from 1985 to 2013 subjected to similar limitations. Exploiting these two settings and difference-in-differences research designs, we provide evidence that the adoption of these tax deductibility limits reduces conditional conservatism of firms’ financial reporting. Overall, our findings suggest that the tax rules affecting the deductibility of interest have important impacts on corporate financial reporting. Such changes can have unintended consequences for other decisions of interest to tax policy makers, such as investment choices documented by others.

Keywords: Tax Deductibility of Interest, Financial Reporting, U.S. Tax Cuts & Jobs Act

JEL Classification: H21, H25, H26, M40, M41, M48