Debt and tax losses: the effect of tax asymmetries on the cost of capital and capital structure
Firms with positive income pay corporate taxes on profits and reduce their total tax burden by claiming various credits and deductions. Firms with negative income and no past profits only claim tax offsets to lower future taxes payable, realizing both taxes on production and investment incentives when they become profitable. This paper looks at the effect of this asymmetric system of partially offsetting losses on the cost of capital. I find changes in marginal effective tax rates depend on the riskiness of investment. Riskless investments see their corporate tax liabilities deferred into the future under a partial-loss system, decreasing their marginal effective tax rate by between 2 and 4%. Risky investments have higher marginal effective tax rates by between 2 and 7%, as they will pay corporate tax immediately if successful and delay receiving investment tax credits and deductions if unsuccessful. Included in these estimates are changes in the effective tax rate due to changes in the capital structure of firms. Loss firms are unable to immediately deduct interest payments, lowering the optimal debt ratio and increasing the cost of financing. I estimate financial decisions under a partial loss system decrease the industry-wide debt-asset ratio between 2-5 percentage points, but these changes have a minimal effect on effective tax rates.