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The Impact of Federal Taxes on the Use of Debt by Closely Held Corporations C

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The Impact of Federal Taxes on the Use of Debt by Closely Held Corporations C USE OF DEBT BY CLOSELY HELD CORPORATIONS THE IMPACT OF FEDERAL TAXES ON THE USE OF DEBT BY CLOSELY HELD CORPORATIONS C. BRYAN CLOYD, * STEPHEN T. LIMBERG, * & JOHN R. ROBINSON * Abstract – It is often asserted that the INTRODUCTION income tax encourages the use of debt because of the deductibility of interest The influence of income taxation on expense. We examine this conjecture by firms’ capital structure decisions is a analyzing the interest incurred by a fundamental tax policy issue. It is often large sample of small, closely held asserted that income taxes encourage corporations. We estimate regressions of firms to use debt in their capital the level of interest on proxies for structures because interest expense is expected future tax rates, interactions tax deductible, thereby creating a tax between the tax rate proxies and subsidy on interest expense that is nondebt tax shields, and other determi- positively related to the tax rate. nants of debt utilization. Our evidence is However, because firms’ total deductible consistent with prior studies in that we expenses are limited to income in any find that firms with high tax rates pay given year, the value of debt tax shields more interest than firms with low tax may be affected by the level of other rates. In addition, firms for which nondebt expenditures that are also additional tax shields might reasonably deductible (i.e., nondebt tax shields). lower tax rates exhibited significant Moreover, the decision to borrow substitution between nondebt tax involves making a trade-off between shields and debt tax shields. the expected tax savings associated with interest deductions and the economic costs associated with in- creased debt (e.g., greater risk of bankruptcy). Thus, the use of debt may be positively related to tax rates only after controlling for nondebt tax shields, *The Department of Accounting, The University as well as nontax determinants of debt of Texas at Austin, Austin, TX 78712-1172. utilization. 261 NATIONAL TAX JOURNAL VOL. L NO. 2 This study investigates the impact of high levels of nondebt tax shields might federal income taxes on debt utilization receive reduced benefits from interest by analyzing a sample of closely held deductions, firms may substitute corporations after the Tax Reform Act of between nondebt tax shields and debt 1986 (hereafter, TRA 86). The sample tax shields. MacKie-Mason (1990) notes derives from the 1988–89 National that this substitution effect will be Survey of Small Business Finances, a strongest for firms that face a substan- unique survey of small, closely held tial probability of losing the tax benefits firms. Although prior studies have of their nondebt tax shields as a result addressed this issue using samples of of increasing their interest deductions. large, publicly held corporations (e.g., We test this tax substitution hypothesis Dhaliwal, Trezevant, and Wang, 1992; by examining whether the extent to Graham, 1996; MacKie-Mason, 1990), which firms substitute debt tax shields there has been virtually no empirical for nondebt tax shields depends upon evidence pertaining to small firms. their expected future tax rates. Moreover, the results of prior research based on samples of large firms may not To control for the potential influence of generalize to smaller, privately held double taxation on C corporation companies for several reasons. First, income, we divide our sample of closely potential bankruptcy costs, as a percent- held corporations into two subsamples: age of firm value, may loom much taxable corporations (C corporations) larger in small firms than in large firms. and electing Subchapter S corporations Hence, smaller firms may have less (S corporations).1 Within each propensity to use debt despite the subsample, we categorize firms into apparent tax benefits. Second, unlike three groups on the basis of expected large publicly held corporations, many future tax rates as represented by their small corporations face a substantial current level of preinterest taxable probability of never becoming profitable income. Firms whose preinterest taxable and may face expected marginal tax income is negative, moderate, or high rates that are near zero. Third, closely are classified as tax exhausted, tax held corporations may not have ready sensitive, or tax insatiable, respectively. access to organized capital markets, and For each subsample, we regress the this may preclude them from achieving ratio of interest expense to gross margin the optimal amount of debt in their on tax group indicators, interactions capital structures. Finally, prior research between the tax group indicators and (Cloyd, Pratt, and Stock, 1996) demon- nondebt tax shields, and other determi- strates that closely held firms respond to nants of debt utilization. some tax incentives differently than publicly held firms. The regression results support the tax hypothesis by providing evidence of a All else equal, if taxes encourage debt significant positive relation between tax utilization, firms that expect high future rates and debt utilization. Moreover, tax rates will make greater use of debt consistent with the tax substitution than firms that expect low future tax hypothesis, our data indicate that the rates. We test this tax hypothesis by extent to which firms substitute examining whether the relative amount between nondebt tax shields and debt of interest expense incurred is positively tax shields depends substantially on related to firms’ expected future income their tax rates. That is, in our sample of tax rates. Because corporations with closely held corporations, tax sensitive 262 USE OF DEBT BY CLOSELY HELD CORPORATIONS firms (i.e., those for which additional tax methods to maximize firm value. This shields might reasonably reduce conjecture is supported by studies that expected tax rates) exhibited signifi- examine specific financing decisions, cantly greater substitution between such as new issuances of debt or equity. nondebt tax shields and debt tax shields For example, MacKie-Mason (1990) than tax exhausted firms (i.e., those for investigates the decision to issue debt or which additional tax shields would likely equity by manufacturing firms, while not reduce expected tax rates). Trezevant (1992, 1994) examines incremental financing decisions sur- The remainder of this study is organized rounding the enactment of tax legisla- into four sections. The first section tion. Graham (1996) simulates marginal reviews prior research and describes the tax rates for a large sample of public hypotheses. The second section describes firms and reports that high tax rate firms the research design and is followed by a issue more debt than their low tax rate section that presents the empirical results. counterparts. Miller, Morris, and Scanlon The final section summarizes the research (1994) also find evidence supporting a and presents concluding comments. link between tax status and financing decisions with a sample of firms that make2 an initial public offering. Scholes, BACKGROUND AND THEORY Wilson, and Wolfson (1990) derive Modigliani and Miller (1963) initially similar evidence from a relatively suggested that the deductibility of homogeneous2 sample of firms in the interest expense could give rise to a commercial banking industry. valuable debt tax shield that could affect firms’ choices between debt and equity Rather than focus on the decision to financing. This hypothesis fostered a issue debt versus equity, the present substantial empirical literature on the study examines a more fundamental effect of taxes on firms’ capital struc- question: the extent to which tax rates tures (e.g., Marsh, 1982; Bradley, Jarrell, influence the level of firms’ interest and Kim, 1984; Long and Malitz, 1985; expense. In addition, we examine the Ang and Peterson, 1986; Fischer, extent to which closely held corpora- Heinkel, and Zechner, 1989; Titman and tions substitute between nondebt tax Wessels, 1988). However, these cross- shields and debt tax shields created by sectional1 studies did not generate consis- the interest deduction. We extend the tent empirical evidence of the effect of work of MacKie-Mason (1990), Graham taxes on firms’ financing decisions. (1996), and Dhaliwal, Trezevant, and Wang (1992), all of which investigate Scholes1 and Wolfson (1992) suggest this substitution effect using samples of that the lack of evidence that taxes large, public corporations. As such, this affect firms’ financing decisions may be study represents an important step due to weak research designs. They toward understanding the more argue that the effect of interest deduc- complex question of how tax incentives tions on capital structure is merely a affect the mix of debt and equity in a small part of a more complex problem, firm’s capital structure. the optimal design of organizations. They suggest that there are many ways The Tax Hypothesis to shield income from taxes and that industry-specific rules or other frictions The value of the debt tax shield is result in firms choosing different directly and positively related to the 263 NATIONAL TAX JOURNAL VOL. L NO. 2 effective tax rate on interest expense. weakened because we cannot distin- Our tax hypothesis is that debt utiliza- guish between the interest generated by tion, as reflected by interest payments, inside and outside debt.3 will be positively related to the firm’s tax rate. In addition, by analyzing C and S The Tax Substitution Hypothesis corporations separately, we allow for the possibility that the relation between Although3 the deductibility of interest debt utilization and tax rates may may create a tax shield, other deductible depend upon organizational form. In expenses and tax credits generate tax the case of C corporations, the effective benefits that can substitute for debt tax tax rate is the corporation’s tax rate plus shields (DeAngelo and Masulis, 1980). some fraction of the shareholders’ For example, the purchase of depre- effective tax rate on shares (Scholes and ciable assets generates depreciation Wolfson, 1992), depending on the deductions and, prior to TRA 86, corporation’s dividend policies. On the investment tax credits.
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