What effect does the corporate income tax have on corporate debt? That’s the topic in our latest edition of a series on the corporate income tax.

More specifically, what are the effects of marginal corporate income tax rates on  corporate debt, as measured by debt-equity ratios? As with the last time, the commentary comes from an article in the American Economic Journal: Macroeconomics, by Simeon Djankov and four co-authors. (You can find a gated version of the article at the website of the American Economics Association, and an earlier, free version at the Harvard Business School.)

The corporate income tax encourages companies to rely heavily on debt, jacking up their debt-to-equity ratios. This was one factor that got Lehman Brothers into trouble. Why does the income tax encourage corporate debt? Because debt payment are deductible. This acts like throwing sand into the gears of firms as they make their financing decisions. Should our tax policy encourage businesses to heighten the risk of bankruptcy?

The Congressional Budget Office (p.3) explains some of the risks of encouraging debt financing:

Businesses may finance investment either by selling ownership shares, or stock (equity), or by borrowing (debt). If firms choose equity financing, investors realize returns in the form of residual profits—that is, the profits that remain after the business pays all of its creditors and suppliers. If businesses finance investment through debt, investors receive their returns as interest. The corporate income tax may distort a business’s decisions about financing because the tax is imposed only on residual profits; it is not imposed on the income a firm pays as interest to investors (because such interest is deductible from the firm’s taxable corporate income). As a result, the tax creates a bias in favor of debt financing, and corporations are likely to be more heavily financed by debt than they would have been without the corporate income tax. That greater dependence on debt financing may increase the chance that companies will not be able to pay their creditors, thus heightening the risk of bankruptcy. Further, shareholders, creditors, and managers have divergent interests that are partly balanced by each company’s chosen mix of debt and equity financing. The corporate income tax may upset that balance by encouraging firms to use too much debt.

Djankov, et. al. find a strong relationship between higher marginal corporate income tax rates and higher debt-to-equity or leverage ratios. Why should our tax code reward debt and punish prudent, conservative financial decision making?

Just as a reminder, here’s the graph that we started this series with. It’s from the article, and visually summarizes the relationship between corporate tax rates and investment.

(For more, see part 1, part 2, and part 3 of this series.)