Thursday, September 16, 2021
Ali Sanati (American; Google Scholar), How Does Removing the Tax Benefits of Debt Affect Firms? Evidence from the 2017 US Tax Reform:
Despite extensive efforts, the relation between tax incentives and corporate capital structure is an open question. The 2017 US tax reform creates an opportunity to directly estimate this relation. The reform limits the tax advantage of debt for all firms except for small businesses with average sales below $25 million. I use the exception threshold in a regression discontinuity design and show that corporate debt declines nearly dollar for dollar as the present value of the tax benefits of debt shrinks. Treated firms do not raise equity to replace debt, and they decrease investments and hiring, consistent with a rise in the cost of external financing. Confirming the tax channel, treatment effects are stronger in firms with more profits and smaller non-debt tax shields. Comparing the size of the debt tax shield across the firm size distribution suggests that the estimates likely provide a lower bound for the effects in large corporations.
Almost all countries still allow firms to fully write off interest expenses against taxable income. This is despite policy proposals to remove such subsidies that allegedly encourage too much debt financing, thereby exacerbating economic downturns (see, e.g., OECD, 2013; IMF, 2016). The US is now an exception, as its tax reform in 2017 limits the amount of interest deductions. Empirically, however, it is an open question whether the tax benefits are a primary determinant of corporate debt policy. Existing estimates range from the tax benefits having no effect, to asymmetric effects, to a first-order positive effect on leverage. This discrepancy is often attributed to the empirical challenges in identifying the effects (Graham et al., 1998; Fama and French, 2002; Graham, 2013). The main goal of this paper is to directly estimate the effects of the tax benefits of debt on firms in the unique setting of the recent US tax reform, which overcomes the challenges in previous studies.