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