How Taxes Affect Economic Behavior

By Henry J. Aaron; Joseph A. Pechman | Go to book overview

ROGER H. GORDON and BURTON G. MALKIEL


Corporation Finance

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

____________________
The authors thank Daniel Frisch, Daniel Feenberg, Elvira Krespach, James Rauch, and Stephen Williams for assistance in the computational work; Alan Blinder, David Bradford, Jerry Butters, Mervyn King, and Richard Quandt for helpful suggestions on earlier drafts of the paper; and the officers of the two financial corporations and of the Securities and Exchange Commission who made available to us their records dealing with the costs involved and settlement terms for several bankruptcies and reorganizations. Finally, we acknowledge financial support from the National Bureau of Economic Research Project on the Changing Roles of Debt and Equity, and from the John L. Weinberg Foundation.
1.
Franco Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance, and the Theory of Investment," American Economic Review, vol. 48 ( June 1958), pp. 261-97.

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