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

Abstract

Using an earnings-based structural model, calibrated with U.S. data for the period 2001-2017, we examine how an interest rate cap for the deduction of interest expense changes the tax benefits of debt. We find that an EBIT-based cap reduces the marginal (total) tax benefits of debt by 5.4% (0.6%) of unlevered firm value for a typical firm. This impact differs across industries due to variations in industry-specific physical capital deployed and associated depreciation. We show that an EBITDA-based structure for a cap reduces the differential impact of a cap across industries. Our results are widely applicable in determining the cost of debt in the presence of these cap structures, enshrined in the US and countries in the OECD.

Keywords: G1, G32, G33