Taxation and Corporate Use of Debt: Implications for Tax Policy

There is growing empirical evidence showing that taxes encourage use of debt in large profitable firms and discourage it in less profitable firms. There has been debate, though, on the source of any non-tax costs from debt finance offsetting the tax advantages of debt. This paper lays out competing hypotheses, notes that the existing empirical evidence is more supportive of a “lemons” model in which lack of information about the viability of borrowing firms inhibits use of debt, and then explores how tax policy should be designed in response.