A RT I C L E OV E RV I EW P R ES E N TAT I O N:C L A R K H I L D A B R A N D

Do Taxes Affect Corporate Financing Decisions?

Jeffrey K. MacKie-Mason

Corporate Taxation Basics

General equation for corporate tax system: Taxes = ([Revenues – Expenses] x τ) – Investment Tax Credit

Expenses can include cash-flow costs of doing business, interest payments, depreciation, and tax loss carryforwards (TLCFs)

Investment Tax Credit (ITC) for 6-10% of investment expenditures discontinued in 1986

Tax exhaustion occurs when a firm has no positive taxable income or cannot claim all of its deductions

Corporate Tax and Investment Theory

Tax Hypothesis advocated by MacKie-Mason Tax shields such as TLCFs and ITCs decrease

attractiveness of financing investment through debt with its interest deductions

Firms with TLCFs have high probability of facing zero tax rates again: TLCFs substantially lower expected marginal τ

Firms with high ITC generally profitable: ITC has little impact on expected marginal τ

Firms with ITC and nearly tax-exhausted less likely to issue debt

Corporate Tax and Investment Theory (cont.)

Disadvantages of Debt Interest commitment might increase likelihood of

financial distress Moral hazard due to conflicts of interest between

managers and lenders can lead to investment inefficiencies

Advantages of Equity Dividend payments of equity signal to investors that

the company is doing well financiallyAssumes a nested decision-making model

with debt and equity as the two public issue options to raise funds for investments

Literature

Myers (1984) and Poterba (1986) found little empirical support for idea that taxes significantly affect financing decisions

DeAngelo and Masulis (1980) showed that a firm’s effective marginal tax rate on interest deductions depends on the firm’s non-debt tax shields

Bradley, Jarrell, and Kim (1984), Titman and Wessels (1988), and other papers espousing the moral hazard hypothesis predict ITC encourages use of debt since ITC high when a firm’s value depends substantially on tangible assets-in-place which lowers moral hazard costs

Basic Econometric Model

Value of incremental debt is a function of potential tax shields (T), T interacting with likelihood of tax exhaustion (T x X), and other factors (Z):

ΔVB = f(T, T x X, Z)Tax Hypothesis predicts T & T x X negatively related

to ΔVB

Other factors include financial distress costs, investment inefficiencies, signaling costs, debt/asset ratio targets, industry dummies, and year dummies

Data

SEC Registered Offerings Statistics tape records the registration of every security for public offering Selected a sample of 1747 registrations from 1977 to 1987 Included only primary, seasoned offerings by firms covered by

the COMPUSTAT tapes Data on firm characteristics from COMPUSTAT Explanatory variables measured during year prior to the

security issue to avoid simultaneity bias Private debt and equity not considered in this article

Uses Altman’s (1968) ZPROB to measure financial condition Lower ZPROB score means less financially secure and more

likely to face zero tax rates

Likelihood Function

The firm’s choice between debt and equity is observed but not the realization of the incremental value of the choice (ΔVi):

ΔVi = x’βi + εi , ~ N(0, Σ)When y = 1, then the firm finances with debt, and

when y = 0, the firm finances with equityEstimates the βi given the observations of debt or

equity issues and the characteristics vector (yn, xn)pr(y = 1 | x) = pr(ΔVB > ΔVE)pr(y = 1 | x) = pr(ε2 – ε1 < x’ β)

Obtains estimates of by maximizing the log of the likelihood function for the sample

Results

Variable (in millions)

Model 1 Model 2 (with 23 industry dummies)

Sample Derivation (in percentage points)

TLCFs -1.86(2.04)

-2.02 (2.00)

-9.36

ITC 28.8(2.18)

27.8(1.91)

8.54

ITC x ZPROB -33.8(2.37)

-33.2(2.18)

-10.8

• As predicted, TLCFs reduce frequency of debt issues since deductibility of interest payments unlikely to sway firms already expecting tax exhaustion

• ITC strongly increases likelihood of debt issues since firms with high amounts of ITC unlikely to reach tax exhaustion

• However, ITC x ZPROB shows that firms nearing tax exhaustion attempt to increase their tax shields and finance through equity

Conclusion

Results confirm the tax hypothesis since the desirability of debt finance at the margin varies positively with the effective marginal tax rate Positive coefficient for ITC does not contradict tax

hypothesis since moral hazard costs outweigh the modest negative coefficient predicted by the tax hypothesis

Summary statistics show strength of the findings with the model correctly classifying the observed choices in the sample 77% of the time

Taxes do affect corporate financing decisions