Impact of Federal Tax on Use of Debt

USE OF DEBT BY CLOSELY HELD CORPORATIONS

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THE IMPACT OF

FEDERAL TAXES ON THE

USE OF DEBT BY

CLOSELY HELD

CORPORATIONS

C. BRYAN CLOYD, *

STEPHEN T. LIMBERG, * &

JOHN R. ROBINSON *

Abstract – It is often asserted that the

income tax encourages the use of debt

because of the deductibility of interest

expense. We examine this conjecture by

analyzing the interest incurred by a

large sample of small, closely held

corporations. We estimate regressions of

the level of interest on proxies for

expected future tax rates, interactions

between the tax rate proxies and

nondebt tax shields, and other determinants

of debt utilization. Our evidence is

consistent with prior studies in that we

find that firms with high tax rates pay

more interest than firms with low tax

rates. In addition, firms for which

additional tax shields might reasonably

lower tax rates exhibited significant

substitution between nondebt tax

shields and debt tax shields.

INTRODUCTION

The influence of income taxation on

firms’ capital structure decisions is a

fundamental tax policy issue. It is often

asserted that income taxes encourage

firms to use debt in their capital

structures because interest expense is

tax deductible, thereby creating a tax

subsidy on interest expense that is

positively related to the tax rate.

However, because firms’ total deductible

expenses are limited to income in any

given year, the value of debt tax shields

may be affected by the level of other

nondebt expenditures that are also

deductible (i.e., nondebt tax shields).

Moreover, the decision to borrow

involves making a trade-off between

the expected tax savings associated

with interest deductions and the

economic costs associated with increased

debt (e.g., greater risk of

bankruptcy). Thus, the use of debt may

be positively related to tax rates only

after controlling for nondebt tax shields,

as well as nontax determinants of debt

utilization.

*The Department of Accounting,...