Taxes are thought to influence corporate decisions in many ways. For that reason, in the past decade a number of changes (or proposed changes) to the U.S. tax code have been made in an attempt to affect corporate behavior. For example, U.S. and European authorities have raised the possibility of eliminating or reducing the ability of companies to deduct interest payments from taxable income, because the tax-favored status of debt has reduced tax revenue collection and allegedly encouraged a "debt bias" of corporations. It is believed that by using too much debt financing, firms may have exacerbated economic downturns. Also, during the last two recessions, in an attempt to stimulate the corporate sector, the U.S. government has temporarily granted companies the ability to carry current-year losses back five years, in order to receive a refund on taxes paid during the past five years. Further, equity tax rates have been decreased for retail investors in an attempt to reduce the corporate cost of capital, and these changes are thought to have increased dividend payout. And, there have been proposals to disallow multinational companies from avoiding income taxes on profits earned overseas by their reinvesting those profits overseas. In this report, I summarize academic research on these and related issues.
In 1958 Modigliani and Miller (M&M) laid the groundwork for modern corporate finance research by demonstrating that when capital and informational markets are perfect, firm value is not affected by financial decisions. Five years later they showed that the existence of taxation can create an environment in which financial decisions affect firm value. In particular, M&M demonstrated that when corporate income is taxed and debt interest is a deductible expense, firm value can be increased by using debt financing rather than funding entirely from equity.
Several branches of research emanated from these basic insights. The first addresses whether the tax environment leads to firm-specific optimal capital structures and value enhancement. If there are costs to using too much debt (for example, expected financial distress costs or personal taxes on interest income), then firms with the greatest benefit to shielding taxes (for example, firms facing higher income tax rates) should be the ones with the greatest incentives to use debt financing. Much of my tax research focuses on how to measure these tax incentives in the context of a dynamic tax code.
One important feature of the tax code is that a firm can "carry back" current losses (by refiling past tax returns) to receive a tax refund for taxes paid in recent years. Alternatively, if carrying back losses is not attractive, then firms can carry forward losses to offset taxable income in future years. Therefore, because the dynamic tax code allows firms to move income through time, it is necessary to forecast future taxable income to estimate current-period tax rates and tax incentives.
Capital Structure Choices and Simulating Corporate Marginal Income Tax Rates
In my early work, I simulated dynamic corporate marginal income tax rates that could explain the probability that a firm will be nontaxable and that allow it to carry losses forward and backward. I then used these simulated tax rates to document that firms respond to tax incentives when they make incremental financing choices, (1) and when they choose the level of debt and the level of leasing. (2) These corporate tax incentives hold up even in the presence of high personal tax rates on interest income. (3)
Most tax and capital structure research, including the work just mentioned, uses data drawn from financial statements, not data from actual tax returns. Given that financial statements consolidate worldwide income statements and balance sheets for multinational firms, but that tax rules and tax incentives vary by country, one might wonder how closely financial-statement-based research mirrors tax return data. …