ROGER H. GORDON and BURTON G. MALKIEL
ANALYZING the effect of the federal tax structure on corporate financial policy is one of the most complex tasks of tax incidence and financial theory. The corporation tax, the personal income tax, the bankruptcy laws, and the costs of financial reorganization must all be considered simultaneously. Yet much of the early literature on the determination of corporation financial structure, the early contribution by Modigliani and Miller being the prime example,1. was developed without consideration of taxes. Even the literature that does allow for the effects of taxation has drawbacks. Many of the implications of the models, such as the conclusion that debt-equity ratios will increase without limit and new equity will never be issued, are clearly counterfactual. Also, there has been little theoretical or empirical effort to measure the efficiency costs of the effects of taxation on capital structure.
The first section of this paper explores various models of corporate financial policy with taxation. We find that, unless allowance is made for both uncertainty and costs of bankruptcy, the models have important____________________