Do Taxes Affect Corporate Financing Decisions? Jeffrey K. MacKie

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
 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 financially
 Assumes a nested decision-making model with debt
and equity as the two public issue options to raise
funds for investments
 Myers (1984) and Poterba (1986) found little empirical
support for idea that taxes significantly affect financing
 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
 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
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 equity
 Estimates 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
(in millions)
Model 1
Model 2 (with 23
industry dummies)
Derivation (in
percentage points)
• As predicted, TLCFs reduce frequency of debt issues since deductibility
of interest payments unlikely to sway firms already expecting tax
• 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
 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

similar documents