The Effect of Taxes on Corporate Financing Decisions: Evidence from a Panel of Italian Firms

This paper provides additional evidence on the relationship between corporate taxes and debt using panel data on Italian companies. The panel covers 1054 companies for the years 1982–1994.The paper follows the Graham-Shevlin methodology for calculating company specific marginal tax rates (MTR) relying on the non-linearity of corporate tax schedules resulting from company losses and the ensuing tax provisions (carry-forward and backward rules). In the period covered by the panel there were in Italy two taxes on corporate income (IRPEG and ILOR), with different loss carry-forward rules, whose statutory tax rates and tax bases changed several times. For these reasons the simulated MTRs display both cross-sectional and time-series variation.The paper tests whether taxes encourage the use of debt by analysing incremental financing decisions. In order to cope with the endogeneity of the MTR the paper considers two different specifications. The first uses the lagged value of the simulated MTR. The second employs the estimate of before-financing MTR proposed by Graham et al. (1998). Significant cross-sectional tax effects are identified under both specifications whereas time-series variation cannot be identified if due account is taken of firm-fixed tax effects.The paper also investigates whether personal taxes affect corporate financing decisions. The MTR may either overstate or understate the fiscal benefit of debt financing according to whether, at the personal level, interest income is taxed at a rate that is higher or lower than the tax rate on returns from common stocks. Differences in the dividend-payout ratio across companies and several reforms in interest, dividend and capital gains taxation provide sufficient cross-section and time-series variations to identify the effect of personal taxes on debt usage.     

Strategic Capital Taxation in Large Open Economies with Mobile Capital

The purpose of this paper is to provide a methodologyfor computing time-consistent, strategic capital taxes in a largeopen economy and to analyze the nature of these taxes. Our resultssuggest that even if a full set of nondistortionary taxes isunavailable and even if the government has redistributive goals,the country which imports capital should tax corporate capitaland the capital exporter should subsidize it. We perform comparativestatics experiments to show how strategically chosen taxes varywith the parameters of the model. JEL classifications: H21,E62     

Local Taxes and Capital Structure Choice

This paper investigates the question of taxation and capital structure choice in Germany. Germany represents an excellent case study for investigating the question of whether and to what extent taxes influence the debt-equity decision of firms, because the relative tax burdens on debt and equity vary greatly across communities. German communities levy local taxes on profits and long-term debt payments in addition to personal and corporate taxes on the federal level. A stylized model is presented incorporating these taxes. The model shows that local taxes create substantial incentives for firms to use debt financing. Furthermore, the paper empirically investigates the effect of local business taxes on the share of debt used to finance incremental investments by German firms. I find that local taxes significantly influence the capital structure choice of firms, controlling for a large number of other factors. In an extensive sensitivity analysis the tax effect are found to be robust across several different specifications.     

Fundamental Tax Reform in The Netherlands

The Netherlands has abolished the tax on actual personal capital income and has replaced it by a presumptive capital income tax, which is in fact a net wealth tax. This paper contrasts this wealth tax with a conventional realization-based capital gains tax, a retrospective capital gains tax with interest on the deferred tax, and a mark-to-market tax which taxes capital gains as they accrue. We conclude that the effective and neutral taxation of capital income can best be ensured through a combination of (a) a mark-to-market tax to capture the returns on easy-to-value financial products, and (b) a capital gains tax with interest to tax the returns on hard-to-value real estate and small businesses.     

Taxes,Inflation and Corporate Financial Policy

This paper examines inflation-induced distortions in personal and corporate income taxes and discusses the implications for corporate dividend and financial structure policies and for shareholder unanimity. The tax effects relating to capital gains and debt interest cause changes in aggregate corporate borrowing and lead to equilibrium tax relationships which differ from the zero-inflation tax relationships.     

Machines,buildings, and optimal dynamic taxes

The effective taxes on capital returns differ depending on capital type in the U.S. tax code. This paper uncovers a novel reason for the optimality of differential capital taxation. We set up a model with two types of capital – equipments and structures – and equipment-skill complementarity. Under a plausible assumption, we show that it is optimal to tax equipments at a higher rate than structures. In a calibrated model, the optimal tax differential rises from 27 to 40 percentage points over the transition to the new steady state. The welfare gains of optimal differential capital taxation can be as high as 0.4% of lifetime consumption.     

Cost of capital and valuation in the public and private sectors: Tax,risk and debt capacity

Cost of capital and valuation differ in the private and public sectors, because taxes are a cost to the private sector but are only a transfer to the public sector. We show how to transform the after-tax private sector cost of capital into its pre-tax equivalent, for comparison with the public sector cost of capital. We establish the existence of a tax induced wedge between these two costs of capital. The wedge introduces a preference on the part of the private sector for assets with rapid tax depreciation, high debt capacity and low risk. We show that, in circumstances where an asset has identical public and private sector valuation in the absence of taxes, the tax induced difference in valuation is identical to the change in government tax receipts that results from having the asset owned by the private rather than the public sector. We provide some examples of distortions that result from failure to adjust for changes in tax revenues, and show how to effect such adjustment.     

Taxes, Leverage, and the Cost of Equity Capital

We examine the associations among leverage, corporate and investor level taxes, and the firm's implied cost of equity capital. Expanding on Modigliani and Miller [1958, 1963] , the cost of equity capital can be expressed as a function of leverage and corporate and investor level taxes. Based on this expression, we predict that the cost of equity is increasing in leverage, and that corporate taxes mitigate this leverage‐related risk premium, while the personal tax disadvantage of debt increases this premium. We empirically test these predictions using implied cost of equity estimates and proxies for the firm's corporate tax rate and the personal tax disadvantage of debt. Our results suggest that the equity risk premium associated with leverage is decreasing in the corporate tax benefit from debt. We find some evidence that the equity risk premium from leverage is increasing in the personal tax penalty associated with debt.     

Personal Taxation in Firm Market Valuation: Theory and Test*

In this paper, I extend Ohlson's 1995 firm market valuation model to incorporate personal taxes: the taxes on dividends and the taxes on capital gains. Without personal taxes, firm market value can be expressed as the present value of future benefits received by the shareholders (dividends, in this case). With personal taxes, the benefits received by the shareholders should be classified into three categories (due to their different tax treatments): dividends, share repurchases, and new share issues (i.e., contributed capital). The extended model shows the effects of personal taxation on firm market valuation: retained earnings are valued less than contributed stocks, both dividends taxes and capital gains taxes affect retained earnings valuation and firm market value, and firms choose cash distribution methods (paying dividends and repurchasing shares) to increase their retained earnings valuation, therefore increasing their market value. An empirical test using a sample from the Disclosure Select Canada and Financial Post Card data bases for the years 1995‐98 supports these personal tax effects.     

Cost of capital equations under the Australian imputation tax system

Since the introduction of the Australian imputation tax system, there have been problems both in the measurement of the market value of franking (imputation tax) credits and in their application to estimating cash flows and the cost of capital. In the present paper, we provide a convenient and robust resolution to the above problems in the context of an internally consistent set of equations for the cost of capital, asset valuation and the capital asset pricing model (CAPM). The equations apply under both classical and imputation tax systems and under differential taxation of dividends, capital gains and interest. The simple form of the CAPM presented here is shown to encompass more complex versions of the CAPM, which attempt to accommodate the effect of personal taxes. The valuation equations require an estimate of the market value of $1 of the firm's dividends, within which is embedded the market value of the imputation tax credits. Separate estimates of the value of imputation tax credits, or Officer's gamma factor, are not required.     

The classical tax system,imputation tax and capital budgeting

Differences in the taxation systems in Britain, France, and some other European countries (which use the imputation system) compared with the USA and the Netherlands, among others (which use the classical tax system), mean that the cost of equity capital should be specified, using a capital asset pricing model methodology, in different ways. Under the imputation system its value should be net of personal taxes; under the classical tax system, it should be gross of personal taxes. Similarly the value of the tax shield on debt for input into adjusted present value calculations differs, being significantly greater under the classical tax system. Formulae are set out to enable the calculation of the magnitude of the tax shield readily to be undertaken.     

Do Personal Taxes Destroy Tax Shields? A Critique to Miller’s (1977) Proposal

We discuss the relevance of personal taxes on tax shields. Interest and taxes are the basis for defining an optimal capital structure. When personal taxes are greater than or equal to TS, an optimal capital structure does not exist.

We suggest that the approach proposed by Miller (1977) might understate the effect of personal taxes in the net TS and/or its associated net value. We consider the irrelevance of personal taxes on interest received by debtholders on the value of TS earned by the firm on interest paid. We conclude that Miller’s approach might be wrong and has some inconsistencies.     

The Impact of Personal Taxes on the Firm's Weighted Average Cost of Capital and Investment Behaviour: A Simplified Approach Using the Dempsey Discounted Dividends Model

The discounted dividends model advanced by Dempsey (1996) is extended to provide a weighted average cost of capital (WACC) assessment of investment opportunities with irregular cash flows. Thereafter, the framework is extended to an assessment of the implications of government tax policy for the firm's investment behaviour. The developed framework is consistent with the empirical evidence of Poterba and Summers (1985) which — over the period of UK tax history 1950–1983 encompassing four major tax on equity reforms — observes how the related dividend and investment politics of UK firms appear to be influenced by the level of dividend taxes.     

Globalisation,taxation and inequality

Today's tax systems, in which value-added taxes and payroll taxes play a prominent role, are largely creations of the 1950s. We need to invent modern tax systems adapted to the reality of the 21^st century: the growing importance of capital and the rise of inequality. This article reviews some of the challenges involved with increasing the progressivity of tax systems in a globalised world and discusses how these challenges could be overcome. I make the case for new and more ambitious forms of international cooperation and for modern forms of wealth taxation.     

Tax reform, the informal economy, and bank financing of capital formation

This paper develops a model that relates businesses’ entry into the underground economy to tax rates and the need to access the banking system. The model uses a dynamic approach in which both firms and banks optimize and in which the benefits to a firm of accessing the banking system are endogenous. A firm compares the return to capital with the marginal tax rate on capital income and uses the difference to determine how much of the tax to pay. At the same time, banks use a firm’s capital tax payments, combined with the capital tax rate to obtain an estimate of the firm’s minimum capital value. If the firm pays at least some taxes then it will have access to the banking system, which will allow it to finance investment. If the firm pays no taxes, then it cannot access the banks and cannot invest. We compare the equilibria resulting from tax compliance and tax evasion. We calibrate the model to a highly stylized version of the Russian economy, and analyze the effect of potential tax changes on the underground economy. We compute a dynamic equilibrium for our model, and note that it tracks the path of certain macroeconomic variables of the Russian economy (GDP, budget and trade balances, price level and interest rate) with some accuracy for the years 2001–2008. We are unable to track the underground economy, as this data is unobservable. We then carry out a series of counterfactual simulations, first asking if non-capital intensive firms have an incentive to evade taxes under existing value added tax rates. We find that they do, and that the incentive would have been greatly reduced if the value added tax rate had been selectively reduced for the non-capital intensive sectors. We then ask what the effect would be if the corporate tax rate were raised on capital intensive sectors. The simulations indicate that the capital intensive sectors would not increase their entry into the underground economy.     

What Can America Learn from the British Tax System?

This paper examines elements of British tax policy and discusses their implications for the US, where several recent proposals would mirror aspects of the British system. These include reducing filing requirements under the individual income tax, indexing capital gains for inflation, cutting mortgage interest deductions, enacting a value added tax, and integrating the corporate and personal income taxes. The paper also discusses implications of the poll tax for tax reform. Britain and America have made different choices involving equity, efficiency, simplicity and other goals. These choices offer the chance to help identify the impact of tax policy. JEL classification: H20.     

How Firms Make Capital Expenditure Decisions: Financial Signals, Internal Cash Flows, Income Taxes and the Tax Reform Act of 1986

This paper empirically assesses the determinants of future net capital expenditures for a broad cross-section of COMPUSTAT firms from 1973 to 1989. We explore three general categories of factors expected to affect investment: (1) external equity financing, (2) internally generated accounting information, and (3) tax incentives. We find that external financing and information plays a role in that both positive stock returns and equity issuances indicate future increases in investment. The results suggest that high stock prices not only lower the cost of capital, but also signal good investment opportunities. Accounting information about internal sources and uses of funds are also important in the investment decision. In particular, net income and depreciation are positive indicators of future investment while there is a tradeoff between the payment of dividends and investment. Further, positive changes in available cash liquidity also motivate future investment. While taxes are not important in the investment decision on average, we find that firms with previously higher income taxes invested substantially more in 1985 and 1986. This coincides with the repeal of the investment tax credit and the accelerated depreciation schedules in the Tax Reform Act of 1986. We view this as evidence that federal tax policy in the 1980's induced firms with high income tax obligations to accelerate capital expenditures just before the favorable tax treatment of capital expenditures was eliminated.     

Capital taxation and accumulation in a growing world economy with deficit finance

Prior analyses of the incidence of capital taxation have assumed that the government budget is balanced and changes in capital taxes affect either other taxes, transfers, or government expenditures. The general conclusion is that an increase in the capital tax rate will increase the gross-of-tax interest rate and decrease capital accumulation. This article examines the steady-state effects of capital taxation on the gross-of-tax interest rate and capital accumulation within a two-country model of overlapping generations, which allows capital taxation to directly affect government budget deficits. It is shown that, under the residence tax system, if the after-tax-interest rate is greater than the growth rate, an increase in the capital tax rate willdecrease the gross interest rate andincrease the capital-labor ratio. This result holds even under the territorial tax system, with some additional assumptions.     

A Note on Intertemporal Fiscal Competition and Redistribution

This paper studies fiscal competition among jurisdictions in a dynamic framework, where the degree of mobility of private capital across jurisdictions boundaries is perfect. The optimal tax on mobile capital is a source tax that taxes away factor rents. Further we show that taxation of mobile capital can redistribute income in favor of the immobile factor labor. This is because the factor rents generated by public inputs and appropriated by mobile capital exceed the efficient level of public expenditure for investments. JEL Code: H21, H23, H42, H71