Taxation, Corporate Capital Structure, and Financial Distress

Mark Gertler and Robert Hubbard ()

No 3202, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Is corporate leverage excessive? Is the tax code distorting corporate capital structure decisions in a way that increases the possibility of an economic crisis owing to "financial instability"? Answering these kinds of questions first requires some precision in terminology. In this paper, we describe the cases for and against the trend toward high leverage, and evaluate the role played by taxation. While provision of proper incentives to managers may in part underlie the trend to the debt, high leverage may in practice be a blunt way to address the problem, and one which opens up the possibility for undue exposure to the risks of financial distress. Our story takes as given the kinds of managerial incentive problems deemed important by advocates of leverage. We maintain, however, that when a firm is subject to business-cycle risk as well as individual risk, a profit maximizing arrangement is not simple debt, but rather a contract with mixed debt and equity features. That is, the contract should index the principal obligation to aggregate and/or industry-level economic conditions. We argue that the tax system encourages corporations to absorb more business cycle risk than they would otherwise. It does so in two respects: First, it provides a relative subsidy to debt finance; second, it restricts debt for tax purposes from indexing the principal to common disturbances. At a deeper level, the issue hinges on the institutional aspects of debt renegotiation. If renegotiation were costless, then debt implicitly would have the equity features relevant for responding to business-cycle risk. However, because of the diffuse ownership pattern of much of the newly issued debt and also because of certain legal restrictions, renegotiation is likely to be a costly activity.

Date: 1989-12
Note: EFG PE
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

Published as Tax Policy and the Economy 4, edited by Lawrence H. Summers, pp. 43-71. Cambridge, MA: MIT Press, 1990.
Published as Gertler, Mark and R. Glenn Hubbard. "Corporate Financial Policy, Taxation, And Macroeconomic Risk," Rand Journal of Economics, 1993, v24(2), 286-303.
Published as Taxation, Corporate Capital Structure, and Financial Distress , Mark Gertler, R. Glenn Hubbard. in Tax Policy and the Economy: Volume 4 , Summers. 1990

Downloads: (external link)
http://www.nber.org/papers/w3202.pdf (application/pdf)

Related works:
Chapter: Taxation, Corporate Capital Structure, and Financial Distress (1990)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:nbr:nberwo:3202

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w3202

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by ().