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Taxation and the optimal constraint on corporate debt finance: why a comprehensive business income tax is suboptimal

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  • Peter Birch Sørensen

    (University of Copenhagen)

Abstract

The tax bias in favour of debt finance under the corporate income tax means that corporate debt ratios exceed the socially optimal level. This creates a rationale for a general thin capitalization rule limiting the amount of debt that qualifies for interest deductibility. This paper sets up a model of corporate finance and investment in a small open economy to identify the optimal constraint on tax-favoured debt finance, assuming that a given amount of revenue has to be raised from the corporate income tax. For plausible parameter values, the socially optimal debt-asset ratio is 2–3% points below the average corporate debt level currently observed. Driving the actual debt ratio down to this level through limitations on interest deductibility would generate a total welfare gain of about 5% of corporate tax revenue. The welfare gain would arise mainly from a fall in the social risks associated with corporate investment, but also from the cut in the corporate tax rate made possible by a broader corporate tax base.

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  • Peter Birch Sørensen, 2017. "Taxation and the optimal constraint on corporate debt finance: why a comprehensive business income tax is suboptimal," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 24(5), pages 731-753, September.
    • Handle: RePEc:kap:itaxpf:v:24:y:2017:i:5:d:10.1007_s10797-016-9432-1
    DOI: 10.1007/s10797-016-9432-1
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    Cited by:

    1. John Freebairn, 2018. "Effective Tax Rates on Different Corporate Investments," Department of Economics - Working Papers Series 2039, The University of Melbourne.

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    More about this item

    Keywords

    Tax bias against equity finance; Optimal constraint on debt finance;

    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H25 - Public Economics - - Taxation, Subsidies, and Revenue - - - Business Taxes and Subsidies

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