The External Effects of Debt: A Back-to-Basics Evaluation of the Tax Penalty for Low Leverage

Abstract

Arguably the most forceful government distortion of the capital market is the differential taxation of debt and equity. Effectively, the government penalizes shareholders when managers choose low leverage. This penalty is sufficiently harsh to be considered a major determinant of the value-maximizing capital structure. Penalizing shareholders for low leverage is efficient only if shareholders' desire for low leverage would otherwise be too strong. Shareholders' desire for low leverage will be "too strong" only if, due to some market failure, low leverage allows shareholders to expropriate the wealth of the firm's external stakeholders. This paper relates leverage to numerous potential wealth transfers between shareholders and external stakeholders, to see whether such transfers might justify penalizing shareholders for low leverage. I examine new data on the two polar extremes of wealth transfers, pollution and charity, and survey an extensive though scattered literature that empirically links leverage to several celebrated "externalities." As predicted by agency theory, in every case if low leverage has a perceptible effect it is to increase the wealth of external stakeholders, at shareholder expense. A similar result is derived from theoretical models of leverage's hypothesized role in preventing poor investments and in freeing up underutilized employees. All of these results have the wrong sign to justify penalizing shareholders for low leverage, suggesting that the tax treatment of debt and equity may be perverse.

JEL Classification: H21, G32