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From interest tax shield to dividend tax shield: A corporate financing policy for equitable and sustainable wealth creation

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  • Zaman, Qamar Uz
  • Hassan, M. Kabir
  • Akhter, Waheed
  • Meraj, M.A.

Abstract

This study critically analyzes debt-incentivized corporate tax and financing policy and provides an Islamic perspective to this important tax deductibility debate. This study advocates that the corporate tax incentive to debt (interest tax shield) be abolished and shifted to equity (dividend tax shield). Later, we use the implications of our proposed taxation policy to reframe the firm financing model and modify M & M's firm valuation model. We use a scenario-based simulation technique and conduct various policy experiments to assess the impact of conventional and proposed tax regimes on levered and zero-levered firms and their values. We find that aligning corporate financing policy with the fundamentals of Islamic finance helps restrain corporate indebtedness and promote profit and loss sharing. According to our proposed model, firms have a reduced cost of financing, tend to be more stable, and are value oriented, especially when they avoid debt to the maximum extent. We further propose that an optimal dividend payout ratio may lead to aggregate equilibrium amongst cost of financing, firm value, and corporate tax contribution to the economy. This study provides new contributions to the discipline of Islamic corporate finance.

Suggested Citation

  • 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.
  • Handle: RePEc:eee:pacfin:v:52:y:2018:i:c:p:144-162
    DOI: 10.1016/j.pacfin.2017.01.003
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    References listed on IDEAS

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    More about this item

    Keywords

    Corporate finance; Islamic finance; Interest tax shield; Dividend tax shield; Stability;

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G35 - Financial Economics - - Corporate Finance and Governance - - - Payout Policy
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • K34 - Law and Economics - - Other Substantive Areas of Law - - - Tax Law
    • Z12 - Other Special Topics - - Cultural Economics - - - Religion
    • H25 - Public Economics - - Taxation, Subsidies, and Revenue - - - Business Taxes and Subsidies

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