Corporate tax incentives and capital structure: New evidence from UK firm-level tax returns


We investigate how companies’ capital structure is affected by corporate income taxes using confidential company-level tax returns for a large sample of UK firms. Exploiting variation in companies’ marginal tax rates, we find a positive and substantial long-run tax effect on leverage. Leverage responds more to decreases in the marginal tax rate, and it responds to changes in the marginal rather than the average tax rate. Most importantly, we find that the marginal tax rate based on tax returns has greater explanatory power for companies’ leverage than the marginal tax rate based on financial statements. Our study suggests that errors in the measurement for tax incentives using financial statements could lead to underestimation of the tax effects on capital structure.

Research Highlights


The impact of investment incentives: evidence from UK corporation tax returns

Many studies have attempted to analyse how taxation affects firms’ capital expenditure. However, few studies have focused explicitly on the role of capital allowances. Given the reduction in capital allowances over time in the UK, and the abolition of capital allowances for investment in buildings, this is potentially an important issue for policy. In this research, we analyse the impact of a 2004 exogenous change in the qualifying thresholds for the first-year depreciation allowances (FYAs), which provides us with a treatment group of firms affected by the change, and a control group of firms that were not affected. We use data from confidential UK corporation tax returns, available from the HRMC Datalab. Results suggest that the investment rate increased by between 2.1 and 2.6 percentage points when firms became qualified for FYAs, relative to firms that did not qualify. This implies a very large average increase in investment rate of 11%. We exploit exogenous variation in the timing of tax payments to show that this large effect is not due to an increase in available cash and hence, is primarily a cost of capital effect.

Giorgia Maffini, Jing Xing and Michael P Devereux. CBT Working Paper 16/01



How does corporation tax affect capital structure?

There is a substantial empirical academic literature which attempts to estimate the impact of taxes on companies’ capital structure – that is, the use of debt and equity as sources of finance. But even in recent years, with widespread availability of data from financial accounting statements, this empirical literature has been plagued by the lack of variation in tax rates which can be used to identify the effects of taxes on the use of debt. Previous studies have typically compared companies in profit- and loss-making positions, but this approach creates many problems. By contrast, a CBT research project employs confidential UK company-level corporation tax return data from the HMRC Datalab. This allows us to exploit variation in the marginal tax rates faced by companies due to the existence of thresholds in the corporation tax rate schedule at which the marginal rate of tax changes. Using a general empirical approach, we find a positive and substantial long-run effect of tax on companies’ leverage. We show that previous studies have typically underestimated these effects since they have relied on imprecise data from financial statements. We find that companies adjust their capital structures gradually in response to changes in the marginal tax rate. We also find that the external leverage of both domestic stand-alone companies and multinational companies respond strongly to corporate tax incentives.

Michael P Devereux, Giorgia Maffini and Jing Xing


Michael P. Devereux, Giorgia Maffini and Jing Xing