Corporate Tax Shields and Capital Structure: Levelling the Playing Field in Debt vs Equity Finance

A common feature within most corporate income tax systems is that the cost of debt is deductible as an expenditure when calculating taxable profits. An unintended consequence of this tax distortion is the creation of under-capitalized firms - raising default risk in the process. Using a difference-in-differences approach, this paper shows that a reduction in tax discrimination between debt and equity finance leads to better capitalized banks. The paper exploits the exogenous variation in the tax treatment of debt and equity created by the introduction of an Allowance for Corporate Equity (ACE) system in Italy, to identify whether an ACE positively impacts banks' capital structure. The results demonstrate that a move to an unbiased corporate tax environment increases bank capital ratios, driven by an increase in equity rather than a reduction in lending activities. The change also leads to a reduction in risk taking for ex-ante low capitalized banks. Overall, these results suggest that the ACE could be a valuable policy instrument for prudential bank regulators.