the distortion in savings decisions created by the taxation of the returns on savings under the income tax.
If an expenditure tax were imposed and the corporation tax repealed, the distortion resulting from the risk of bankruptcy would disappear. However, if the corporation tax were left in place, the distortion would increase; we estimate excess burdens would rise by $3.5 billion. This suggests that proposals for an expenditure tax, if not accompanied by repeal of the corporation tax, should at least be accompanied by a reduction in the distortion favoring debt finance resulting from the corporation income tax.
Further analysis of an expenditure tax is beyond the scope of this paper. It is clear, however, that tax reformers should be concerned about the corporation tax when advocating a movement toward an expenditure tax.
In this paper, we have developed a model of corporate financial decisions when there is both uncertainty and the possibility of costly bankruptcy. This model was used to measure the distortions in behavior induced by the existing tax structure and their excess burden costs. The effects on efficiency costs and revenues of various possible modifications of existing taxes were also explored, and several major conclusions drawn.
First, as long as firms are competitive, explicit recognition of bankruptcy costs is essential if a model is to explain the observed corporate financial structure.
Second, debt-capital ratios increased steadily between 1946 and 1974, and have declined only slightly since then. This rise was accompanied by, and according to our theory was caused by, a simultaneous rise in nominal interest rates, and by increasing optimism (or reduced pessimism) about prospects for the economy, at least until the early 1970s.
Third, the efficiency costs arising from tax incentives to increase debt- capital ratios are substantial, on the order of $3 billion a year, or approximately 10 percent of corporation tax revenues.
Fourth, distortions in the allocation of capital for corporate and noncorporate uses do not appear to be as large as previously thought. Our estimate is one-quarter to one-third of the size of earlier estimates.
Finally, any of several directions of tax change aimed at lessening the distortion in debt-capital ratios merit serious consideration.