The Impact of Personal and Corporate Taxation on Capital Structure Choices

Abstract

Die Dis cus si on Pape rs die nen einer mög lichst schnel len Ver brei tung von neue ren For schungs arbei ten des ZEW. Die Bei trä ge lie gen in allei ni ger Ver ant wor tung der Auto ren und stel len nicht not wen di ger wei se die Mei nung des ZEW dar.Dis cus si on Papers are inten ded to make results of ZEW research prompt ly avai la ble to other eco no mists in order to encou ra ge dis cus si on and sug gesti ons for revi si ons. The aut hors are sole ly respon si ble for the con tents which do not neces sa ri ly repre sent the opi ni on of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp08020.pdf Non-Technical SummaryCapital structure adjustments can be used to reduce the total tax burden on company investment since the taxation of the return on equity and debt capital differs in most countries. At the corporate level, interest payments reduce taxable profits while such a deduction is not feasible in the case of equity financing. At the shareholder level, effective tax rates on dividend and interest income differ as well. Therefore, the relative tax benefits of different sources of finance are supposed to have an impact on financing decisions.Theory suggests that both corporate profit tax and personal capital income taxes shouldbe considered in order to analyze the tax impact on capital structure choices.Since previous literature mainly focuses on the taxation of corporate profits, empirical evidence with respect to the possible impact of personal capital income taxation on capital structure choices is still scarce. Therefore, this paper aims at analyzing the effects from different taxation of equity and debt on capital structures of European firms while taking into account both personal and corporate income taxation. For the empirical analysis we employ a rich panel of firm-level financial accounting data of companies located in 23 European countries, taken from the AMADEUS data base. In contrast to other recent papers, we focus mainly on stand-alone companies. Furthermore, we collect detailed information about the tax systems of the considered countries during the period from 2000 until 2005.The empirical results suggest that a higher tax benefit of debt has the expected significant positive impact on companies' financial leverage. Additional analysis confirms that debt ratios are affected by personal income taxation: the level of dividend taxes has a positive impact on the debt to assets ratio, whereas the taxation of personal interest income negatively affects corporate leverage. In addition, we find evidence that the capital structures of smaller companies react more heavily to higher tax benefits of debt. In contrast, this tax benefit only has a minor impact on the financial decisions of parent companies belonging to a group of affiliated firms. Zusammenfassung (Summary in German)

Empirical Evaluation of Interest Barrier Effects

“…This is plausible, because, while some kind of debt is required by all kind of rms, a certain rm size may boost the ability to tap external sources. Overesch and Voeller (2010) use the interactions between loss carryf orward and str and, in addition, str and tangibility in order to show that the postive tax eect on the debt to assets ratio decreases for rms with high non-debt tax shields. We nd the same expected negative eects of both of these interactions on the total, internal and external leverage.…”

“…The corporate tax rate eect on nancing decisions has been summarized in a literature review by Graham (2003) and in a meta study by Feld, Heckemeyer and Overesch (2011). Rajan and Zingales (1995), Graham (1999), Alworth and Arachi (2001) and Overesch and Voeller (2010) do not only focus on the positive eect of corporate tax rates on the debt level, but also try to identify a proposed negative eect of high personal taxes on interest.…”

Differential Taxation and Firms' Financial Leverage: Evidence from the Introduction of a Flat Tax on Interest Income

“…Therefore, in a robustness check we exploit international variation in global ultimate ownership and use an identification strategy similar to that of Overesch and Voeller (2010). This approach makes use of the fact that In our data, for many firms we observe the type and country of residence of the global ultimate owner, who is defined as the ultimate shareholder who directly or indirectly holds more than 50% of a firm's equity.…”

“…with respect to the (unobservable) degree of financial constraints they face Peterson, 1988, 2000). Using international firm level data, Overesch and Voeller (2010) exploit variation in taxation between European countries and find a significant negative effect of the tax rate on interest income on the debt ratio of firms. Fuest and Weichenrieder (2002) use aggregated country data and similarly find that lower taxes on personal interest income versus corporate income decrease the share of corporate savings in total private savings.…”

Personal taxation of capital income and the financial leverage of firms

“…with respect to the (unobservable) degree of financial constraints they face Peterson, 1988, 2000). Using international firm level data, Overesch and Voeller (2010) exploit variation in taxation between European countries and find a significant negative effect of the tax rate on interest income on the debt ratio of firms. Fuest and Weichenrieder (2002) use 5 For a comparison of interest rates, we refer to the return of corporate bonds instead of deposits because of their comparable level of risk.…”