Business Wealth and Tax Policy

Abstract

This study has two major purposes. First, we extend capital structure model (CSM) research so that it can be applied to both ownership forms of forprofit organizations (FPOs): pass-throughs and C corp. We do this by deriving the first pass-through CSM equations. These equations complement the extant C corp CSM equations. Second, we derive new CSM equations to test tax policy reform. Since FPOs are responsible for most of federal tax revenue, these equations can produce outputs showing how FPO business wealth and federal tax revenue are changed when tax policy reform makes business growth more affordable by not taxing FPO earnings that are retained for growth. After deriving these new equations, we provide data in the form of effective tax rates and growth rates as well as a methodology to compute costs of borrowing. This data and methodology show how CSM equations can be applied to FPO studies. The major area of originality concerns the notion that both business wealth and federal tax revenue can increase if governments reform their tax policy by granting tax shields that promote growth while simultaneously doing away with tax shields that distorts owner efficiency caused by favoring debt over equity.

Pass-Through and C Corp Outputs under TCJA

“…Second, we test g L = 3.90%, which is consistent with the Tax Policy Center, TPC, (2018) that cites sources predicting that TCJA, on average, will increase GDP by about 0.8%. Thus, and as also pointed out by Hull (2019), a g L of 3.90% is consistent with a growth rate of 3.12% increasing by about 0.8%. Third, we test g L = 4.50%, which represents the two growth projections given by TPC that are at the high end.…”

“…As noted by Hull and Price (2015), while large CCs can float large bond issues and undertake a variety of large short-term borrowings, PT debt financing often includes regional and national mezzanine borrowings that permit the issuance of unsecured and subordinated notes at high interest rates. Hull (2019) writes that PTs can also borrow from individuals, banks, savings and loans, credit unions, commercial finance companies, and Small Business Administration (SBA) guaranteed loans where the latter have methods of encouraging bank and non-bank lenders to make long-term loans to PTs. Compared to CC debt, PT debt is less likely to be assigned a credit rating by a major credit rating company.…”

“…Since this formulation by Baxter, the trade-off argument has been modified to incorporate other leverage related effects such as those posited by agency theory (Jensen and Meckling 1976;Jensen 1986). While the mainline trade-off models focus on CCs, the Capital Structure Model (CSM) provides a trade-off framework that covers both CCs (Hull 2018) and PTs (Hull 2019).…”

“…Researchers (Leland 1998;Graham and Harvey 2001;Graham and Leary 2011) suggest capital structure theory is imprecise, offers vague direction, and accounts for only part of the known behavior regarding debt choices. As noted by Hull (2019), the heart of this indictment suggests that searching for an adequate capital structure model presents difficulties. In our quest to identify an adequate model, we focus our search on a perpetuity model that computes outputs for the three categories debt choice, valuation, and leverage gain when an unlevered firm chooses among finite debt choices.…”

“…To answer our research questions, this paper uses the Capital Structure Model (CSM) that was recently extended by Hull (2019) to incorporate PT equations within a framework that formerly only addressed CCs. By using the CSM, we avoid measurement problems found in agency models (Jensen and Meckling 1976;Jensen 1986) and pecking order models (Myers 1977;Myers and Majluf 1984).…”