In a recent study, published in the European Accounting Review (EAR), Zhenhua Chen, Padmakumar Sivadasan, and I take a new look at the capital structure implications of taxes. Financial economists have long wondered why many companies fail to take full advantage of the corporate tax benefits from debt. Financial distress and other costs should offset the tax benefits to some degree, but the corporate tax benefits of debt are substantial. This has led many to question the perceived underleverage of so many corporations and the ‘mystery’ of zero-leverage firms. Low- or zero-leverage firms appear to leave large amounts of tax dollars on the table.
Merton Miller’s solution was to propose a personal tax disadvantage from debt that offsets corporate tax benefits to at least some degree. This traditional personal tax disadvantage occurs because tax authorities generally tax interest from debt at a higher rate than they tax dividends and capital gains from equity. Therefore, standard tax models specify two tax components to the gain from leverage: (a) the corporate tax benefit; and (b) the partially offsetting traditional personal tax disadvantage from debt. Notwithstanding this personal tax disadvantage, the net tax gain from leverage can still be substantial.
We expand the traditional specification of the tax gain from leverage by accounting for the choice between issuing debt and utilizing internal retained earnings equity. Standard analyses focus solely on the choice between debt and external equity. Expanding the debt analysis to include internal equity introduces a third tax component to the gain from leverage: a supplemental personal tax disadvantage. This supplemental disadvantage reflects the personal tax cost of distributing internally-generated equity to investors and using replacement debt. It reduces the overall or comprehensive tax gain from leverage and frequently converts it into a tax loss. In fact, in a broad sample of thirty-one nations, the estimated upper bound for the supplemental personal tax disadvantage for high-tax investors averages 13.7 percent for the year 2019. With this supplemental tax, the average overall or comprehensive tax gain from leverage for high-tax investors across nations is in fact decidedly negative for 2019; internal equity is the tax-favored way to finance corporate investments. This result could help explain the underleverage puzzle and the phenomenon of zero-leverage firms.
From a corporate policy perspective, this tax preference for internal equity over debt challenges the premise of the prominent capital-structure tradeoff theory, which assumes debt provides a tax advantage over equity. From a comprehensive perspective, there is often no net tax advantage from debt to trade off against the financial distress, agency, or other nontax costs of debt. From a fiscal policy perspective, our analysis suggests that efforts to remove the tax bias in favor of debt may not always be warranted. In many tax regimes, the most compelling tax bias favors internal retained earnings equity, not debt.