4-Tax impact

4)- Impact of tax rates on financial leverage decision

The tax saving from using debt was indicated as the second major reason for financial leverage. This would imply that the higher the tax rate, the greater the tax saving from debt, and consequently the more companies will use debt. Table T-11.6 shows the aggregate equity to total assets ratio for all corporations in the United States and the an aggregate effective tax rate calculated by dividing aggregate tax paid by aggregate profits for all businesses in the United States for the period of 1973 to 1996 (data from IRS Statistics of Income as reported in Statistical Abstract of the United States).

Table T-11.6
Proportion of equity funding and tax burden 1973-1996
.	Equity/total	Effective corporate income tax rate
1973	0.26	0.44
1974	0.25	0.45
1975	0.26	0.47
1976	0.26	0.45
1980	0.26	0.42
1982	0.26	0.41
1983	0.26	0.41
1984	0.26	0.41
1985	0.26	0.41
1986	0.26	0.39
1987	0.26	0.37
1990	0.26	0.33
1991	0.28	0.33
1992	0.28	0.33
1994	0.30	0.34
1995	0.31	0.34
1996	0.33	0.35
IRS statistic of income: Corporate Income Tax returns, selected Financial Items in Statistical Abstracts

Table T-11.6 shows that the proportion of equity increased (form 26% to 33%), implying that the proportion of debt decreased (from 74% to 67%) over the 23 years, while the effective tax rate dropped (from 44% in 1965 to 35% in 1995) over the period. The hypotheses that a higher tax will push businesses to borrow more seems to be verified based on this empirical data. However, whereas the tax change of the 1980's was large, the decreased use of debt was minimal and delayed; thus the data is not fully convincing. There may be some other tax consideration than just the federal corporate tax rate (such as State corporate income taxes, other taxes and the lifting of the capital gains tax relief) that may have played a role. Moreover, tax considerations are certainly not the only or major consideration for a capital structure strategy.

Proportion of tax revenue collected from corporate income tax in 1988, as a percentage of the total country tax burden

United States 8.4%
France 5.2%
Germany 5.3%
Japan 24.4%

A rigorous comparison of debt financing among different countries would be informative, but it is difficult to conduct because of the differences in capital markets and tax provisions. A casual observation of corporate income tax burdens in Europe, Japan and the United States has a message. In Japan, where the corporate income tax rate is the highest, corporation are known to be much more leveraged than in the United States. In Europe (i.e. France and Germany) the corporate income tax rate is mild because most business related tax collection is concentrated in the value added tax, and as one would expect less debt is used than in the United States.

See review questions Q-11B4.1 and Q-11B4.2.

See research assignment R-11B4.1.

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