Do Taxes Affect Corporate Financing Decisions?

TLDR

Prior research has overlooked the negligible impact of most tax shields on marginal tax rates and has relied on ratio tests, whereas incremental financing decisions offer greater analytical power. The study employs discrete choice analysis of incremental financing decisions to test new predictions about tax effects. The analysis demonstrates that tax considerations substantially influence the choice between debt and equity, clarifying the link between tax shields and debt policy.

Abstract

ABSTRACT This paper provides clear evidence of substantial tax effects on the choice between issuing debt or equity; most studies fail to find significant effects. The relationship between tax shields and debt policy is clarified. Other papers miss the fact that most tax shields have a negligible effect on the marginal tax rate for most firms. New predictions are strongly supported by an empirical analysis; the method is to study incremental financing decisions using discrete choice analysis. Previous researchers examined debt/equity ratios, but tests based on incremental decisions should have greater power.