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Should interest expenses be tax deductible?

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  • Karpavičius, Sigitas
  • Yu, Fan

Abstract

This paper analyzes how shareholder wealth, firm characteristics, and public finance would be impacted if tax deductibility of interest expenses were eliminated. We find that shareholder value would decrease by 3.5%. Under the new regime, firms would be smaller and less levered, would have less productive capital, and would feature lower default probabilities. The effects on aggregate output and employment would be negative. However, the government's revenues from corporate income tax would increase by 3% in the long-run and could be used to partially offset the negative side effects of the reform. The current period of historically low corporate bond yields is probably the best time to change the treatment of interest expenses.

Suggested Citation

  • Karpavičius, Sigitas & Yu, Fan, 2016. "Should interest expenses be tax deductible?," Economic Modelling, Elsevier, vol. 54(C), pages 100-116.
    • Handle: RePEc:eee:ecmode:v:54:y:2016:i:c:p:100-116
    DOI: 10.1016/j.econmod.2015.12.017
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    Cited by:

    1. Cordelia Omodero, 2022. "The Role Of Corporate Tax, Earnings And Debt In Determining Dividend Policy Of Firms," Business Management, D. A. Tsenov Academy of Economics, Svishtov, Bulgaria, issue 3 Year 20, pages 46-69.
    2. Zaman, Qamar Uz & Hassan, M. Kabir & Akhter, Waheed & Meraj, M.A., 2018. "From interest tax shield to dividend tax shield: A corporate financing policy for equitable and sustainable wealth creation," Pacific-Basin Finance Journal, Elsevier, vol. 52(C), pages 144-162.

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