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Debt and Creative Destruction: Why Could Subsidizing Corporate Debt be Optimal?

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  • Zhiguo He
  • Gregor Matvos
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    Abstract

    We illustrate the welfare benefit of tax subsidies to corporate debt financing. Two firms engage in a socially wasteful competition for survival in a declining industry. Firms differ on two dimensions: exogenous productivity and endogenously chosen amount of debt financing, resulting in a two dimensional war of attrition. Debt financing increases incentives to exit, which, while socially beneficial, is costly for the firm. Therefore the planner can increase welfare by subsidizing debt financing. The duration of industry distress determines the tradeoff between the welfare benefit illustrated in our model and the costs of subsidizing corporate debt from the existing literature. Our theory also sheds light on why the IRS considers "conflict of interest" as one of the key determinants in identifying securities that are qualified for tax-benefits.

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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17920.

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    Date of creation: Mar 2012
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    Handle: RePEc:nbr:nberwo:17920

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    1. John R. Graham, 2000. "How Big Are the Tax Benefits of Debt?," Journal of Finance, American Finance Association, vol. 55(5), pages 1901-1941, October.
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    Cited by:
    1. Rogers, Robert P., 2013. "Bankruptcy and steel plant shutdowns," The Quarterly Review of Economics and Finance, Elsevier, vol. 53(2), pages 165-174.

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