Report Detail Summary

Tax Rates and the Corporate Capital Structure

February 18, 2019

Corporations have at their disposal three return delivery mechanisms for any pre-tax corporate income: Interest on corporate debt, dividends and the capital gains generated by retained earnings. Profit and shareholder maximization suggest that the corporation will attempt to deliver the returns to shareholders in a tax efficient manner. At any point in time the corporation will assess the costs of delivering returns to investors, inclusive of corporate and personal income taxes. Our hypothesis is straight forward, changes in the tax structure alter the attractiveness of the different return delivery mechanism and that in turn induces a change in the capital structure of a corporation. How much and how quickly the change takes place depends on institutional restrictions which we generically call “adjustment costs”. All of this suggest that changes in the capital structure will not be instantaneous and could last several years. This is an important issue, if we find evidence to suggests a correlation between these two sets of variables, then we have found evidence that the changes in the tax code alters the capital structure in predictable ways and provides evidence in support of a supply-side response. Our conclusion is that as before the data is consistent with positive adjustment costs in the capital structure as evidenced by the gradual changes in the relative shares of the different return delivery vehicles. The Trump tax rate cuts also altered the keep rate, but in a different way. The tax rate cuts effectively equalized the keep rate of the different return delivery vehicles. Unlike the other tax rate changes already mentioned, the Trump tax rate cut is neutral to the capital structure of a corporation. It does not tilt the balance in favor of one vehicle over another. Tis is an issue that is not frequently discussed in the press or by financial analysts. Nevertheless, the Trump administration deserves much credit for broadening the corporate tax base in a neutral way. Yet this does not mean that the Trump tax rate cuts will not have an impact on the capital structure. The neutral rate cuts mean that those activities that prior to the rate cuts were disadvantaged will now gain as they are taxed at the same rate. Their keep rate will increase. The big loser here is financial engineering techniques which relies on corporate debt and the creation of strategies to arbitrage the differential tax rates of the different vehicles.

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