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Curbing corporate debt bias: Do limitations to interest deductibility work?

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  • De Mooij, Ruud
  • Hebous, Shafik

Abstract

Tax provisions favoring corporate debt over equity finance (“debt bias”) are widely recognized as a risk to financial stability. This paper explores whether and how thin-capitalization rules, which restrict interest deductibility beyond a certain amount, affect corporate debt ratios and mitigate corporate default risk. We find that rules targeted at related party borrowing (the majority of today's rules) have no significant impact on debt bias, as they do not affect third-party borrowing. These rules also have no effect on broader indicators of firm corporate distress. Rules applying to all debt, in contrast, turn out to be effective: the presence of such a rule reduces the debt-asset ratio in an average company by 5 percentage points; and they reduce the probability of a firm being in financial distress by 5 percent. Debt ratios are found to be more responsive to thin capitalization rules in industries characterized by a high share of tangible assets.

Suggested Citation

  • De Mooij, Ruud & Hebous, Shafik, 2018. "Curbing corporate debt bias: Do limitations to interest deductibility work?," Journal of Banking & Finance, Elsevier, vol. 96(C), pages 368-378.
  • Handle: RePEc:eee:jbfina:v:96:y:2018:i:c:p:368-378
    DOI: 10.1016/j.jbankfin.2018.07.013
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    Cited by:

    1. Nicola Comincioli & Sergio Vergalli & Paolo Panteghini, 2019. "Business tax policy under default risk," CESifo Working Paper Series 7664, CESifo.
    2. Ruud Mooij & Li Liu, 2020. "At a Cost: The Real Effects of Transfer Pricing Regulations," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 68(1), pages 268-306, March.
    3. Serena Fatica & Wouter Heynderickx & Andrea Pagano, 2020. "Banks, Debt And Risk: Assessing The Spillovers Of Corporate Taxes," Economic Inquiry, Western Economic Association International, vol. 58(2), pages 1023-1044, April.

    More about this item

    Keywords

    Corporate tax; Capital structure; Debt bias; Thin capitalization rule;

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • H25 - Public Economics - - Taxation, Subsidies, and Revenue - - - Business Taxes and Subsidies

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