Taxation and Corporate Financial Policy

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1 Taxaion and Corporae Financial Policy Alan J. Auerbach Univeriy of California, Berkeley and NBER February 2001 Thi paper ha been prepared for a forhcoming volume of he Handbook of Public Economic, edied by Alan Auerbach and Marin Feldein. I am graeful o Kevin Cole for reearch aiance, o he Burch Cener for Tax Policy and Public Finance for reearch uppor, and o Doug Bernheim, John Graham, Jim Hine, Vea Kanniainen, Han-Werner Sinn and Jan Söderen for commen on an earlier draf.

2 Taxaion and Corporae Financial Policy ABSTRACT Thi paper review he heory and evidence regarding he impac of axaion on corporae financial policy. Saring from a baic characerizaion of he claical corporae income ax and i effec, he analyi focue on hree area of reearch: equiy policy, deb-equiy deciion, and choice regarding ownerhip rucure and organizaional form. The dicuion ree he diincion beween nominal and more fundamenal financial difference for example, in he relaionhip beween borrowing and leaing and ha financial policy involve choice no only among differen underlying policie bu alo among characerizaion of a given policy. The final ecion offer ome brief reflecion on he implicaion of coninuing financial innovaion. JEL Claificaion: H32, G30 Alan J. Auerbach Deparmen of Economic 549 Evan Hall Univeriy of California Berkeley, CA

3 1. Inroducion Like oher counrie ha rely on he income ax a a ource of revenue, he Unied Sae diinguihe beween corporaion and individual. U.S. corporaion and individual face eparae ax chedule and differen rule regarding income and deducion. Under hi claical yem of corporae axaion, here i limied coordinaion, or inegraion, of he wo ax yem: axe on hareholder are aeed independenly of he axe on he corporaion hey own. By conra, many oher counrie have aemped o effec ome form of inegraion of corporae and individual income axe. However, even in hee counrie, adjumen have aken he form of parial meaure, leaving he corporaion income ax wih independen effec. Through he year, economi have devoed coniderable effor o underanding he incidence of a diinc corporaion income ax and i impac on he invemen and financial deciion of firm. Thi chaper review he porion of hi lieraure ha ha focued on corporae financial policy, including choice abou firm ownerhip rucure. Oher chaper in hi Handbook, by Fulleron and Mecalf and by Hae and Hubbard, conider more fully he iue of incidence and invemen, repecively. Poerba chaper focue on he effec of axaion on he financial deciion of houehold, raher han firm, and Gordon and Hine deal wih he coniderable complicaion inroduced by open-economy capial movemen. However, he dicuion below mu, of neceiy, ouch on he iue covered more fully in hee oher chaper. The incidence of he corporaion income ax depend, in par, on he naure of financial equilibrium; he real and financial deciion of firm are independen only under rericive aumpion; corporae financial deciion hould be eniive o he axe faced by he owner and poenial owner of heir ecuriie; and he domeic financial equilibrium will depend on ax rule ha influence foreign capial flow.

4 1.1. Wha i financial policy? In he imple erm, financial policy relae o wo key choice ha firm make: (1) how much of heir capial rucure o uppor by deb, raher han equiy; and (2) how much of heir earning o reain for ue a inernal equiy finance, raher han diribuing dividend and raiing new equiy in he marke. In wo landmark paper, Modigliani and Miller (1958) and Miller and Modigliani (1961) demonraed, under cerain aumpion, ha neiher of hee deciion maered, having no effec on firm value and hareholder wealh. Thee paper launched he modern lieraure on corporae financial policy, eablihing a benchmark again which deviaion from he M-M aumpion uch a he exience of axe could be evaluaed. The key inigh of he M-M analyi i ha marke valuaion hould relae o underlying claim o income ream, raher han o how ae are labeled. A porfolio coniing of a lile riky equiy and a lo of afe deb hould have he ame value a a econd porfolio wih a lo of le riky equiy and a lile afe deb if he underlying rik of he wo porfolio i comparable. We hould go beyond erm like deb and equiy o conider he characeriic of he claim hemelve. Over he year, hi leon ha been emphaized by he evoluion of financial inrumen uch a leae, which may ac a ubiue for deb, and opion, he valuaion of which can, once again, be underood by conrucing comparable porfolio wih and wihou opion and requiring ha hey have he ame value (Black and Schole 1973). A challenge o analyzing he impac of axaion on firm deciion, hough, i ha he ax yem i baed in large par on formal label, and only indirecly on underlying ae characeriic. Thu, equiy face one e of ax rule and deb anoher, ofen more favorable, o pecial rule are needed regarding he reamen of he riky deb ha more cloely reemble equiy. Equiy repurchae are reaed 2

5 more favorably han are dividend bu, again, rericion exclude from hi favorable reamen hare redempion ha oo cloely reemble dividend. Evaluaing he impac of axe on firm behavior require ha we underand he rule ha apply in diinguihing among differen ype of ae. Financial policy deciion ofen amoun o chooing he opimal rade-off beween diorion o financial policy and he ax benefi uch diorion generae. Indeed, a major ax avoidance aciviy coni of rying o improve hi rade-off, conrucing ae and ranacion o permi corporaion o characerize heir financial deciion in a manner mo favorable from he ax andpoin. The impac of axaion, hen, depend no only on he ax yem ielf, bu alo on where he ax yem definiional line are drawn and how well hey can be moved hrough ax avoidance aciviy Ouline of he chaper Each of he hree ecion ha follow deal wih an imporan apec of corporae financial policy, repecively equiy policy, deb-equiy deciion, and choice regarding ownerhip rucure and organizaional form. The final ecion offer ome brief reflecion on he implicaion of coninuing financial innovaion. The dicuion below relie heavily on my previou urvey paper (Auerbach 1983a) wih repec o developmen in he lieraure up o ha paper wriing, and on he ecion in Auerbach and Slemrod (1997) concerning he impac of he Tax Reform Ac of 1986 on financial policy. 2. Corporae equiy policy While rik i an eenial componen of he heory of corporae financial deciion, a ueful aring place o analyze he effec of axaion i a model wihou rik. Alo echewing for he momen he imporan queion of inveor heerogeneiy, we conider he behavior of a 3

6 repreenaive firm whoe ecuriie are owned by a repreenaive individual, wih firm and individual each facing i own, diinc ax yem, and no proviion ha inegrae he wo. The baic approach follow ha laid ou in King (1974, 1977), Auerbach (1979b), Edward and Keen (1984) and, for he coninuou ime analogue ued here, Sinn (1987). Corporaion face a ingle income ax rae, τ, which will ener he analyi laer, while individual face diinc ax rae θ on dividend and c ( θ) on accrued capial gain. In realiy, capial gain are generally axed on realizaion raher han on accrual, a diincion ha i imporan from he perpecive of houehold porfolio reallocaion deciion. However, incorporaing a realizaion-baed capial gain ax would complicae he preen analyi grealy, and i no a imporan in hi conex. The accrual-equivalen alernaive, c, hould be hough of a being coniderably le han he acual capial gain ax rae, becaue i ake ino accoun he fac ha no all gain are realized in every year, and ha gain realized in he fuure benefi from a deferral advanage. 1 Le V be he value of he firm a ime. I i alo ueful o inroduce he meaure S o repreen he value of new hare iued a dae. If S < 0, hen he firm i a ne repurchaer of i own hare. Le D be he firm oal dividend paymen a dae, and le ρ be he dicoun rae ha he repreenaive inveor applie o he cah flow and capial gain generaed by he firm. Capial marke equilibrium require ha he afer-ax rae of reurn equal ρ: D V& S (2.1) ρ = ( 1 θ ) + (1 c), V V 1 King (1977) dicue he conrucion of accrual equivalen meaure. Poerba chaper in hi Handbook dicue capial gain axe and heir effec. 4

7 where he econd erm on he righ-hand ide of (2.1) reflec he fac ha increae in hare value due o exenive growh hrough hare iuance are no axable. Rewriing (2.1) a a imple fir-order differenial equaion in V: ρ (2.2) V = V& 1 θ + D S 1 c 1 c (where V& i he rae of change of V wih repec o ime, ) and olving forward uing he erminal condiion ha dicouned firm value converge o zero, we obain he following expreion for firm value a dae : (2.3) V = e ρ ( ) 1 θ 1 c D 1 c S d Expreion (2.3) i valid for any pah of dividend and hare iue, and o can erve a a bai for deermining he opimal choice of hee wo variable o maximize firm value. Thee choice are no independen, and are furher conrained by echnological and legal conrain on he firm. The mo obviou conrain i ha impoed by he firm ne cah flow: ne cah leaving he firm equal dividend le ne new hare iue. If we define G a he ne proceed from he firm operaion before he deerminaion of dividend and new hare iue, hen hi conrain i: (2.4) G D S In addiion, dividend canno be negaive (D 0). However, here may be furher conrain on he paymen of dividend. For example, one migh imagine firm finding i neceary o pay ou 5

8 a cerain hare of heir earning a dividend. A dicued furher below, he moivaion for uch behavior require a richer model han he curren one, noably ome combinaion of aymmeric informaion and a divergence of inere beween hareholder and corporae manager. However, for he momen, we can imply conider he implicaion of impoing uch a conrain, a in: (2.5) D p D + V& S ) ( which require ha dividend equal a lea a fracion p of he firm oal reurn. 2 There may alo be effecive rericion on hare repurchae, which have he aracion over dividend of facing capial gain ax rae. Alhough here have been legal rericion on repurchae elewhere, impedimen in he Unied Sae are limied o axaion, reaing repurchae a dividend if hey are diribued in proporion o hare ownerhip. While oher mehod of repurchaing (via he open marke or hrough ender offer) are unlikely o reul in proporional ale by differen inveor, repurchae have, excep during cerain period, been uncommon relaive o new hare iue and dividend. Thi ugge ha here may be facor beyond hoe explici in he model ha limi a firm abiliy o repurchae i hare, by making i coly o do o. Perhap mo imporanly, repurchae from inveor who volunarily ender heir hare may alo be ubjec o he non-ax co aociaed wih aymmeric informaion. When firm have he poenial o ake advanage of endering hareholder, and an incenive o do o (perhap 2 While hi i a paricularly imple conrain, impoing a more general co relaing o he dividend payou raio lead o a imilar oucome. See Poerba and Summer (1985). The key i ha an increae in earning lead o an increae in dividend. The ame concluion alo applie o he conrain on hare repurchae given below in (2.6); he reul when ha conrain bind are imilar o hoe derived from a more general co of enering he exernal equiy marke. 6

9 in he inere of remaining hareholder) heir deciion o repurchae equiy may aach a premium o he hare hey eek o acquire. Barclay and Smih (1988) provide empirical evidence in uppor of hi claim. A uggeed by Brennan and Thakor (1990), hee co can lead o a iuaion in which firm ue repurchae only for large diribuion, when he advanage of a repurchae overcome he co of acquiring informaion abou he rue value of he firm. A argued by Myer and Majluf (1984), uch co may be aociaed wih enering he exernal equiy marke and hence applicable o new hare iue a well, cauing hare price o fall upon he announcemen of a new iue (Aquih and Mullin 1986). Bu firm impelled o iue new hare have no oher ource of exernal equiy fund, while hoe conemplaing a repurchae do have he opion of paying dividend. Thu, in a richer model in which uilizing he exernal equiy marke i coly, we migh oberve firm iuing equiy bu no repurchaing equiy. We reurn o hi queion below bu, again, begin imply by conidering he impac of uch an effecive conrain, (2.6) S 0 To conider he policy ha maximize firm value (2.3) ubjec o he conrain (2.4) (2.6), we ue (2.4) o ubiue for S in (2.3), (2.5) and (2.6) and form a Lagrangean: (2.7) V = e ρ ( ) 1 θ 1 c G + D 1 + λ ( D pv& pg ) + µ 1 c ( D G ) d where he muliplier λ and µ are aociaed wih he conrain (2.5) and (2.6), a lea one of which will be binding a any given dae. 7

10 8 Expreion (2.7) i complicaed by he preence of he erm V& on he righ-hand ide. To implify, we ake he derivaive of (2.7) wih repec o ime o obain a fir-order differenial equaion analogou o (2.2) and olve uing he ame approach ued o reach (2.3). The reul i: (2.8) ( ) = dv p c d c D p G p e V v µ λ θ µ λ λ λ ρ ) )(1 (1 The fir-order condiion wih repec o dividend, D, i: (2.9) c = θ µ λ o ha he econd erm in bracke on he righ-hand ide of (2.8) vanihe. Thu, he firm value, a an opimum, i: (2.10) = dv p c d G p e V v λ µ λ ρ 1 1 ) )(1 (1 Auming ha θ >c, a lea one of he muliplier in (2.9) mu be nonzero. A he margin, iuing new hare o pay dividend increae axe (he increae in dividend axe exceeding he reducion in capial gain axe) and reduce he value of hare. Thi co i refleced by he negaive erm c θ in expreion (2.8). To maximize value, firm will wih o decreae boh new hare and dividend unil a lea one of he conrain bind. We many diinguih hree regime, according o wheher λ, µ, or boh are poiive. Though firm migh wich among regime over ime, i i helpful o conider fir he implicaion for firm permanenly in one regime or anoher.

11 2.1. The radiional view (m = 0) When only he minimum-dividend conrain bind, expreion (2.10) reduce o: (2.11) V = e ρ ( ) [ 1 (1 p) c pθ ] G d According o hi expreion, he value of he firm equal he preen value of i cah flow ne of new hare iue and dividend, dicouned wih a before-peronal-ax dicoun rae reflecing an individual ax rae on equiy income ha i a weighed average of he ax rae on dividend and capial gain. In hi regime, a fixed hare p of he cah flow from any marginal invemen are paid ou a dividend and axed a rae θ, wih he remainder being reained and axed a rae c. Thi regime ha been aid o reflec he radiional view (ee, e.g., Poerba and Summer 1985), becaue i include wo andard concluion. The fir concluion i ha boh dividend and capial gain axe raie he corporae dicoun rae, which equal ρ. The [ 1 (1 p) c pθ ] econd i ha, a he margin, firm will increae value by inveing o he poin a which he marginal valuaion of a dollar of new invemen i one dollar. Thi la poin may be een by noing ha reducing a hareholder wealh by one dollar and increaing he preen dicouned value of fuure cah flow G by one dollar leave he repreenaive hareholder indifferen o he oucome The new view (l = 0) When only he hare-repurchae conrain bind, expreion (2.10) reduce o: (2.12) V = e ρ ( ) 1 θ 1 c G d, 1 c 9

12 a valuaion expreion ha ha wo riking implicaion. Fir, he appropriae dicoun rae, ρ, i unaffeced by he ax rae on dividend, regardle of he dividend yield. Second, he ( 1 c) 1 θ ne cah flow of he firm are muliplied by he raio 1. Thi reul wa called he 1 c new view of dividend axaion (e.g., Auerbach 1981), which, of coure, i wa a he ime i fir received eriou analyi a an alernaive o he view laid ou above, in analye by King (1974), Auerbach (1979a) and Bradford (1981). The inuiion underlying he new view i ha, wih he hare-repurchae conrain binding, he firm will neiher iue nor repurchae hare. Thu, i marginal ource of equiy fund will be reained earning. Likewie, any ubequen cah flow generaed by a marginal invemen will be paid ou fully a dividend hey canno be ued o reduce hare iue, which are already zero. Hence, he ax conequence of boh curren invemen and fuure cah flow differ from he previou cae. The ax benefi of avoiding curren dividend axe upon invemen reduce boh he dicoun rae and he equilibrium valuaion of marginal invemen. Conider, for example, a dicree-ime example of a firm deciion wheher o inve an addiional dollar a dae ha yield a gro payoff (afer all corporae axe) of 1+r dollar a dae +1. The co of reaining a dollar i reduced by he dividend axe aved, and increaed by he capial gain axe on induced hare appreciaion, q. Becaue he value of new invemen per dollar equal i co o he hareholder, in equilibrium, q = 1-θ+cq, or 1 θ q =. One 1 c period laer, hi invemen plu i reurn i worh [ 1 + r(1 c ] q ) q per iniial ne dollar forgone, if all earning are reained. If all earning in he ubequen period are paid ou, hen he 10

13 hareholder receive 1+r(1-c) from he firm, a diribuion ha force he hareholder o pay [1+r(1-c)]θ in dividend axe, which will be parially offe by he capial gain ax avoided hrough he paymen of he dividend, q[1+r(1-c)]c. On ne, he benefi of he enire ranacion i [ 1 + r (1 c)](1 θ + cq). In eiher cae, a long a ax rae are conan over ime, he value per q iniial dollar inveed i 1+r(1-c). Thu, he dividend ax rae play a role in valuing he firm, bu doe no influence i invemen. Anoher way o view hi equilibrium i ha individual face a ax on capial income of c θ c and a ax on dividend diribuion of. While he capial income ax affec he co of 1 c capial, he exra ax on diribuion affec only value, coniuing, eenially, a capial levy ha i analogou o ha impoed by he cah-flow componen of he conumpion ax (Auerbach and Kolikoff 1987). Even hough he levy i no aeed immediaely, i ineviabiliy caue i o be capialized ino hare price, a reul refleced in he heory alernaive characerizaion a he rapped equiy view. Wheher he equiy really i rapped i, of coure, a cenral queion, o which we reurn below The inermediae cae (l, m > 0) Beween he wo regime ju dicued i a regime in which boh conrain bind. In hi iuaion, firm pay minimum dividend and iue no new hare. In erm of he value of he firm, hi regime i inermediae beween he radiional and new regime, ranging from he former for mall value of µ o he laer for mall value of λ. Characerizing he co of capial i more complicaed, becaue he muliplier may ake on a range of value, and he co of capial depend no only on he curren value of hee muliplier, bu alo on heir rae of 11

14 change. 3 However, for conan value of µ and λ, he co of capial, alo, will lie beween hoe of he wo previou regime. Which of hee regime i mo likely o occur depend upon he relaionhip beween he firm invemen and i cah flow, a i depiced in Figure 2.1, which illurae he equilibria correponding o differen invemen demand chedule, labeled D H, D M, and D L. The chedule S repreen he upply of fund, and reflec he fac ha exernal fund are more coly o he firm han inernal fund. 4 For firm wih high level of invemen demand relaive o cah flow, a repreened by demand curve D H, he maximum level of reained earning, F 0, i far hor of invemen, and he equilibrium will be a poin T, wih new hare iue needed a a upplemenary ource. For firm wih low level of invemen relaive o cah flow, a repreened by demand curve D L, he level of reained earning available a he dividend conrain exceed he amoun needed o finance invemen, o dividend will be reduced unil he hare repurchae conrain bind, a poin N. Beween hee wo regime, a a poin I, firm will finance all invemen hrough reenion, no finding addiional invemen profiable enough o juify he more expenive exernal equiy fund, bu finding invemen profiable enough no o increae dividend and reduce invemen. For firm in hi regime, a hif in he level of inernal fund, ay from F 0 o F 1, will increae invemen, providing one of he heoreical argumen in uppor of he oberved dependence of invemen on cah flow (e.g., Fazzari e al. 1988). 3 The general expreion for he co of capial i given in expreion (3.3) below. 4 A already dicued, he co of fund for he inermediae regime will depend no only on he value of µ and λ, bu alo on hee muliplier rae of change. Thi will be rue, oo, for firm raniing ou of one of he oher wo regime, for which he muliplier will be changing. However, for given fuure value of he muliplier, he co of fund will ill be higher if exernal fund are ued currenly, a in he conan-muliplier cae ju analyzed. 12

15 Alhough movemen among regime can be driven by hif in eiher demand or upply chedule, i i a ueful implificaion o hink of firm wih inernal fund ha are adequae o finance invemen a maure and hoe wih ronger demand relaive o exiing fund a immaure. The reuling claificaion lead o he noion (Sinn 1991a) of a life-cycle proce for firm wih repec o equiy ax regime, a o-called nucleu heory in which he firm begin in he radiional regime and evenually make he raniion o one in which inernal fund uffice. Thi diincion highligh he fac ha equiy axaion may repreen a barrier o enry for new firm (Judd and Peeren 1986) Corporae ax inegraion The diincion beween hee alernaive view of he impac of hareholder-level axe i highlighed by he iue of corporae ax inegraion, which encompae a range of policie aimed a alleviaing he double-axaion of corporae-ource equiy income. All uch policie involve a reducion in axe on dividend, eiher a he hareholder level, hrough a direc reducion in ax rae or hrough credi or deducion ha have he ame effec. The wo approache adoped mo commonly in pracice around he world are he impuaion yem ha provide ax credi o hareholder on dividend received and he pli-rae yem ha axe corporae earning diribued a dividend a a lower rae. Alhough hee yem differ in heir deail, hey are fundamenally equivalen in heir incidence and incenive effec, lowering he oal ax burden on dividend. Their impac can be analyzed by conidering a reducion or eliminaion of he ax rae on dividend, θ. The analyi depend on he ize of he reducion in he effecive ax rae on dividend. If θ i reduced bu remain greaer han c, he model a preened above applie. Under he radiional view, firm would receive a reducion in heir co of capial; under he new view, 13

16 only he capial levy would fall, wih no impac on he co of capial. If θ fall below c, hen neiher of he conrain (2.5) or (2.6) will bind, he aociaed muliplier will be zero, and he hree regime dicued above collape o one. Thi i becaue firm will now reduce axe and gain from iuing hare o pay dividend. Some addiional conrain i neceary o preven infinie ax arbirage, and one i ypically preen in exiing yem ha reric he ax relief o dividend aribuable o previouly axed corporae earning. Thu, once all earning have been diribued, here i no furher ax incenive o diribue. In our model, he eaie way o repreen hi i by a conrain ha limi dividend o all earning, (2.13) D + V& S D Inering hi conrain in (2.7) in place of he previou wo conrain yield, in place of (2.8), 1 1+ γ (1 c )(1+ γ v ) (2.8 ) V = e G ( 1+ γ ) ρ dv + D 1 θ 1 γ 1 c d where γ i he muliplier aociaed wih (2.13). Maximizing value wih repec o D again 1 θ make he la erm in bracke vanih, wih γ = 1, allowing u o rewrie (2.8 ) a: 1 c (2.14) V = e ρ ( ) 1 θ G d, Thu, we can hink of inegraion a having he ame impac in all regime, lowering he co of capial, once equaliy beween θ and c i reached. Up o ha poin, inegraion i le 14

17 effecive a lowering he co of capial in he radiional regime (becaue p < 1) and no effecive a all in he rapped-equiy regime. 5 I here a way o make inegraion cheme more effecive? Becaue he radiional view applie only o he exen ha firm ue new hare a heir marginal ource of equiy fund, a ax benefi baed on new hare iue, raher han dividend paymen, would eem o be he anwer. One propoal floaed in he Unied Sae during he 1980 would have given firm a parial deducion for dividend paid (like a pli-rae yem), wih he ize of he deducion baed on he hare of dividend aribuable o equiy iued afer he legilaion effecive dae. 6 Thi cheme i baically imilar o he Annell deducion preen in Sweden during he 1970 and 80 (King and Fulleron 1984, p. 95). Why aren uch cheme more commonly ued? A ubidy o new hare iue raie he queion of how repurchae hould be reaed. All firm, even hoe iuing new hare, would have an incenive o repurchae all ouanding hare and iue new one o qualify for he deducion. The naural repone i o impoe a ax on repurchae ha offe any uch poenial ax benefi. However, axe on repurchae would hi no only uch churning ranacion, bu alo ranacion by firm engaging in ne repurchae. Such aciviy i, of coure, inconien wih he conrain (2.6), bu hi conrain reflec a rericive, implifying aumpion. Repurchae do occur, even if hey are le common han ax facor alone would ugge. One imporan example of repurchaing i he cah-financed akeover in which one firm redeem he hare of i arge company. Taxing uch ranacion would be a conroverial policy change. 5 In a mall open economy, anoher reaon why inegraion may no affec he co of capial i ha he equilibrium rae of reurn may no be deermined by domeic hareholder. For furher dicuion, ee Boadway and Bruce (1992) and Devereux and Freeman (1995). 6 The propoal wa fir decribed in American Law Iniue (1992). See Auerbach (1990) for furher dicuion. 15

18 2.5. Evaluaing he model Reearcher have aemped o evaluae he alernaive heorie of he impac of dividend axaion by eing hee heorie implicaion regarding financial and invemen behavior and marke valuaion. While he predicion appear o differ harply, eing ha proved challenging due boh o daa limiaion and he fac ha heorie hemelve derive from a implified model ha omi cerain elemen of realiy ha complicae he inerpreaion of reul. For example, he fir approach one migh hink of would be o examine he acual paern of equiy finance. We oberve, for example, ha mo firm do no iue new hare in a given year, which would eem o uppor he new view. On he oher hand, if firm face fixed co of iuing new hare, hey migh effecively ue new iue a he margin by engaging in large, periodic iue. Apparenly conradicing he new view i he exience of hare repurchae. Repurchae, alway preen o ome exen in he Unied Sae, began o grow during he mid-1980, in concer wih he merger wave ha occurred a he ame ime, a firm ued cah o purchae he hare of oher firm, in addiion o heir own (Bagwell and Shoven 1989). Thi growh, paricularly among large firm, led o he inference ha firm finally had dicovered how o avoid dividend axaion. More recenly in he Unied Sae, here ha been a growh in he percenage of firm no paying dividend (Fama and French 2000). However, he implicaion are no o clear. Noe ha wha i crucial for he new view i he relaive axaion of he ource and ue of fund. For example, if firm obain equiy fund by reducing repurchae and reaining earning, and diribue fund by increaing repurchae and dividend in he ame proporion, hen he new view i eenially inac. All ha i needed i o apply a differen value of he peronal ax rae inead of θ o reflec he fac ha ome diribuion are axed a rae θ and oher are axed a rae 0 (Sinn 1991b). The ame logic 16

19 would apply if firm reained earning and iued equiy o finance invemen and ued he proceed of invemen o increae dividend and reduce new hare iue in he ame proporion. Thu, rejecion of he new view require howing no only ha dividend are an unimporan marginal ource of fund, bu alo ha reducing he iuance of new hare i an unimporan marginal ue of fund. A piece of evidence on hi paricular implicaion i dicued below. 7 Moving beyond imple oberved paern of finance, reearcher have eed oher implicaion of he alernaive heorie. In a widely cied paper een a providing empirical evidence in favor of he radiional view, Poerba and Summer (1985) eimaed equaion baed on Tobin q-heory of invemen. Thi heory predic ha invemen by firm facing convex adjumen co will be poiively relaed o he relaionhip beween he marginal value of capial, q, proxied by he ock marke value per uni of capial, and he long-run equilibrium value of capial, q*, i.e., I = q f. Under he radiional view of axaion, wih marginal q * equiy fund coming hrough new hare iue, q* = 1. Under he new view, q* = 1 θ. 1 c Uing powar daa from he Unied Kingdom, Poerba and Summer eimaed invemen equaion of he form I = q f ω q + (1 ω), acceping he hypohei ha ω = 1 (1 θ ) (1 c) bu rejecing he hypohei ha ω = 0. However, hi reul relie on cerain rericive aumpion. Fir, he calculaion of θ and c require ha one idenify he marginal inveor whoe ax rae deermine valuaion 7 Even under he aumpion of he radiional view ha he firm relie on equiy iue a a ource of fund bu no a a ue of fund, he co of capial may be independen of he dividend ax rae. An example i provided by 17

20 under he new view. Poerba and Summer ued average marginal ax rae, a eemingly raighforward approach. Ye he marginal equiy inveor ideniy depend on he naure of financial equilibrium. If, for example, he Miller equilibrium dicued below in Secion 3 prevail, hen he appropriae value of θ and c are inead hoe for inveor who are ju indifferen beween deb and equiy. Given ha idenificaion in he U.K. ample come from frequen change in ax rule affecing dividend, error in meauring he change in 1 θ 1 c would end o bia he reul in favor of he radiional view. Second, he e i meaningful only if he aumpion of he q-heory ielf are aified, among hem ha firm face convex adjumen co, capial i homogeneou and accuraely meaured, and reurn o cale in producion are conan. There ha been a coninuing dipue abou he naure of adjumen co, and even recen evidence in uppor of he q-heory uing panel daa (Cummin, Hae and Hubbard 1994) ugge ha aggregae meaure of q conain coniderable noie, and ha e baed on hee uch a hoe performed by Poerba and Summer would be biaed. A econd empirical finding ofen aken o favor he radiional view i ha dividend payou raio repond poiively o he reurn o a before-ax dollar of dividend relaive o a before-ax dollar of capial gain, 1 θ. While hi evidence cerainly uppor he argumen 1 c ha axe influence dividend policy (and herefore conradic he o-called ax irrelevance view baed on he hypoheical availabiliy of offeing ax arbirage raegie), i i le clearly evidence in favor of he radiional view pecifically. Bernheim (1991), who develop a ignaling model in which he fracion of diribuion aking he form of dividend raher han repurchae repond o change in he dividend ax rae o preerve he average ax rae on diribuion. 18

21 The argumen ha hi evidence i inconien wih he new view i baed on he new view predicion ha he level of dividend axe ha no impac on he incenive o inve or pay dividend. However, here are wo diinc reaon why an increae in dividend axe would reduce diribuion under he new view. Fir, a emporary increae in he dividend ax rae doe raie he co of paying dividend under he new view, for i reduce he opporuniy co of fund more han he ulimae burden on he reurn o invemen. Indeed conien wih hi logic, Poerba and Summer (1985) found (baed again on an analyi of UK daa) ha dividend fall wih a curren rie in dividend axe and rie wih an anicipaed rie in dividend axe, even when he level of dividend ax rae i held conan. Second, an increae in he dividend ax ypically doe no occur in iolaion. In he Unied Sae, for example, dividend and inere are axed a he ame rae for individual inveor. An increae in dividend axe alo raie he ax rae on inere income, a change ha make corporae invemen more aracive by raiing he ax burden on alernaive invemen. Thu, i hould pur more corporae invemen and, under he new view, a reducion in dividend. Tha he co of paying dividend may increae wih he dividend ax rae even under he new view help in inerpreing relaed evidence on dividend ignaling. In a udy ha focued on he queion of wheher ax-baed ignaling drive dividend policy, Bernheim and Wanz (1995) reaoned ha if dividend are ued a a ignal, heir informaion conen hould relae o heir co. Hence, he increae in value in repone o a uni increae in announced dividend hould be higher during period wih a higher ax penaly on dividend. Looking a he period , Bernheim and Wanz eimaed ha he informaion conen per dollar of dividend fell 19

22 along wih he ax rae on dividend in 1981 and again in While heir meaure of he co of dividend wa baed on he radiional view, heir finding i no necearily inconien wih he co of paying dividend baed on he new view: he relevan co under he new view migh well have fallen over ime a well. For example, anicipaion of reducion in marginal ax rae prior o 1981 and again before 1986 hould have raied he opporuniy co of paying dividend relaive o he co afer rae had reached hiorically low value afer 1986 and would no have been expeced o fall furher. Oher evidence, baed on micro-daa, ugge ha neiher pure regime applie o all firm, bu ha ome firm appear o behave a prediced by he new view. For he Unied Sae, Auerbach (1984) eimaed ha firm iuing new hare required a higher rae of reurn on invemen han hoe no iuing new hare, a would be he cae if he repecive co of capial of he wo group were hoe of he radiional and rapped-equiy regime. Bond and Meghir (1994) found a higher eniiviy of invemen o inernal fund among U.K. firm wih low or no dividend payou. Auerbach and Hae (2000) found ha iuance of new hare iue wa ju a reponive o inernal cah flow a o invemen among all firm ha have paid dividend a ome poin in heir oberved hiory, conrary o a key radiional view aumpion. Wih repec o dividend policy, hey found ha dividend reponded more rongly o invemen and inernal cah flow among U.S. firm wih characeriic aociaed wih weaker acce o exernal capial marke. 3. The deb-equiy deciion For corporaion, inere paymen are ax deducible, bu reurn o equiy inveor are no. Dividend are ubjec o double axaion, and even reurn o equiy in he form of capial 20

23 gain are ubjec o a lea one level of ax, a he corporae level. Thu, here appear o be a rong ax incenive o ue deb o fund he firm aciviie. Conider again he firm valuaion under opimal equiy policy, a given in (2.10). Recall ha we defined G a he ne proceed from he firm operaion before he deerminaion of dividend and new hare iue. Le u now divide G ino hoe flow before inere and deb, X, and hoe aociaed wih deb, B, he laer flow equal o ne borrowing le afer-ax inere paymen: (3.1) G X + B& i ( 1 τ ) B where i i he inere rae a dae. Inering (3.1) ino (2.10) yield: dv (1 c)(1 λ v p) µ (3.2) V = e 1 ( X + B& i (1 τ ) B ) ρ 1 λ p d Maximizing V wih repec o B yield he fir-order condiion V B d ( V B& ) d = 0. Leing α µ = 1 be he adjumen erm muliplying corporae cah flow a dae, 1 λ p hi fir-order condiion implie ha (3.3) ρ i (1 τ ) = (1 c)(1 λ α& p) α The righ-hand ide of (3.3) i he firm co of equiy capial a dae, aking accoun no only of he direc co of fund bu alo he capial gain or loe aociaed wih a hif in equiy 21

24 policy regime. 8 The lef-hand ide of (3.3) i he ne co of borrowing, o (3.3) call for he firm o equae he co of deb and equiy. If he equiy regime i fixed over ime and α doe no change, hen condiion (3.3) imply require ha ρ i (1 τ ) =, where φ = [1-(1-c)(1-λp)] i 1 φ he effecive ax rae on reurn o equiy, ranging from a value of c when λ = 0 (i.e., under he new view) o (1-p)c + pθ when 1 θ λ = 1 (he radiional view). 1 c For a ingle, repreenaive houehold alo o be indifferen beween deb and equiy, i mu be he cae ha he reurn afer individual axe are equal, or i(1-ψ) = ρ, where ψ i he individual ax rae on inere income. Thi yield he following condiion for firm opimizaion: (3.4) (1-τ)(1-φ) = (1-ψ) Expreion (3.4) ha a raighforward inerpreaion. The lef-hand ide i he ne reurn o he individual inveor of a dollar of corporae ource income axed a an equiy reurn. The righhand ide i wha he ame dollar would yield if paed hrough a an inere paymen. Noe, hough, ha if all ax rae are given, here i nohing obviou ha will caue he equaliy in (3.4) o be aified; firm will no achieve an inerior oluion, and will increae or decreae deb unil ome oher conrain bind. In he apparenly likely cae ha (1-τ)(1-φ) < (1-ψ), one would obain a corner oluion wih an all-deb oucome. Some have embraced hi argumen. Perhap mo prominen i Sigliz (1973), who uggeed ha firm hould ue equiy o cover he capializaion of idea, hereby avoiding immediae capial gain axe, bu ha deb hould uppor any new invemen by exiing 8 Thi erm implie ha equiy i more coly a he firm make he raniion from he radiional regime, due o capial loe a he valuaion of capial aume i rapped-equiy level. 22

25 enerprie. However, hi predicion eem a variance wih he evidence. Though deb-equiy raio have varied acro counrie and ime period, equiy finance ha generally accouned for a larger hare han deb of corporae capial rucure, a lea in he aggregae. Thi ecion review he differen heorie of corporae leverage, and he aociaed empirical evidence. The imple explanaion for why firm don borrow more i ha, a he margin, here exi non-ax co ha offe he ax advanage of doing o. To underand hee co, i i fir neceary o clarify he characeriic ha diinguih deb from equiy, for ax purpoe. According o ax rule in he Unied Sae and elewhere, deb involve a fixed commimen o make paymen, while equiy doe no. Thu, he more deb a firm iue, he greaer i commimen of fuure cah flow o making inere paymen, and he greaer he probabiliy ha i cah flow will be inadequae o cover inere paymen. Thi increae he probabiliy of bankrupcy or oher financial dire, he reource co aociaed wih which would be aken ino accoun when making he iniial borrowing deciion. Tha hee co maer o ome exen i uppored by he effor made by ax auhoriie o deny inere deducibiliy o deb for which commimen o pay inere and principal are weakened. In he Unied Sae, for example, here are limi on he deducibiliy of inere on non-recoure deb (for which credior lierally have no recoure if paymen are no made) and on very long-erm deb, for which principal repaymen i of lile concern. A econd poible non-ax co o borrowing derive from he informaion aymmery beween poenial lender and borrower. In an environmen where lender canno diinguih beween good and bad rik, advere elecion may occur, a firm ha are relaively le riky will be dicouraged by he large rik premium impoed by lender, and only he bad rik will find borrowing aracive (Sigliz and Wei 1981). 23

26 Ye anoher imperfec-informaion explanaion relae o he moral hazard problem of firm ha can aler heir invemen choice o ake advanage of deb-holder. Wih limied liabiliy, firm face a one-ided be when making riky invemen: if heir invemen fail, he downide rik i runcaed. A illuraed in Figure 3.1, which depic wo poible reurn diribuion, any reurn below ha labeled A would induce bankrupcy. Increaed leverage raie he poiion in he reurn diribuion a which failure occur, a hown in he figure in he move from poin A o poin B. Bu he impac differ according o he underlying rik of he firm ae. The rikier he firm ae, he greaer he hare of he diribuion ha will be runcaed by he hif. Hence, firm may be encouraged o underake rikier invemen, o ake greaer advanage of limied liabiliy. In Figure 3.1, hi migh make he high-rik invemen more aracive han he low-rik invemen, depie i full diribuion having a lower mean reurn. One may view he abiliy o walk away from loe a a pu opion ha credior provide a par of he lending conrac. Underaking rikier invemen increae he value of hi pu opion. Credior, of coure, would charge for hi pu opion were he firm invemen raegy known and fixed, bu uch a wealh ranfer canno generally be avoided oherwie. The more difficul i i o monior a firm aciviie, and he eaier i i for a firm o aler i ae porfolio, he more of a problem hi poenial moral hazard impoe and he higher a premium lender would ini on (Myer 1977). The aociaed inefficiency in he choice of invemen projec would hu be impounded in he co of borrowing. While each of he previou explanaion relae o why value-maximizing firm migh limi heir borrowing, manager migh well op hor of opimal borrowing becaue of a divergence beween heir incenive and hoe of heir hareholder. Manager wih high deb load migh well be forced o work harder, heir human capial a coniderable rik hould he 24

27 firm be forced ino bankrupcy. Though hi effec increae he aracivene of deb from he hareholder perpecive, i ha quie he oppoie impac on manager, who would find he propec of coniderable free cah flow much more enicing (Jenen 1986). In addiion o hee heorie of borrowing, here are oher ha relae more direcly o he apparen ax incenive hemelve. In reponding o he apparen inequaliy in favor of deb finance (1-τ)(1-φ) < (1-ψ) he heorie ugge ha (1) φ in a large a one migh hink; (2) τ may be maller han he auory corporae ax rae; and (3) ψ may be much larger han φ for he relevan individual inveor. The fir of hee argumen follow from he new view of equiy axaion dicued above. From ha perpecive, hareholder face only he capial gain rae on marginal equiy reurn, even hoe ha flow in he form of dividend. If φ = c, and c i very mall, hen he deb-equiy deciion re roughly on he relaive magniude of τ and ψ, which may no be far apar. The oher wo explanaion, which we now explore in more deail, are ha he abiliy o deduc inere paymen may be limied, and ha he relevan marginal inveor i one for whom he corporae ax advanage for deb i offe by a peronal ax advanage for equiy Compeing ax hield The abence of a unique inerior opimum in imple model of he deb-equiy deciion follow from he fac ha ax rae are aumed no o change wih he deb-equiy raio. Thu, if he inequaliy (1-τ)(1-φ) < (1-ψ) hold a a low deb-equiy raio, i will hold a higher debequiy raio and coninue o encourage borrowing. Thi reul require ha inere paymen be deducible a he corporae ax rae, τ, regardle of heir magniude. Bu corporae ax rule do no conform o hi aumpion. Inead, hey limi deducion for inere and oher expene o he exen ha hee deducion would induce negaive axable income and ax refund. Tha i, 25

28 if he corporaion earning before inere and axe, or EBIT, are E, and i inere deducion are I, hen he ax yem rea poiive and negaive value of (E-I) aymmerically, (3.5) T = τ(e-i) if (E-I) > 0 τ*(e-i) if (E-I) < 0 wih τ* < τ. 9 The imple uch aymmery i ha τ*=0 no deducibiliy for loe bu ax yem ypically provide ome ax benefi even for firm wih loe hrough he abiliy o carry loe forward or backward o oher ax year. We dicu below how one eimae he value of uch unued curren deducion. The likelihood ha a firm inere paymen exceed i EBIT depend no only he debequiy raio, bu on oher elemen of he ax yem a well. If he ax yem meaured a corporaion income accuraely hen, in a rik-le world, i would be poible o finance all invemen by borrowing and ju deduc all inere paymen. To ee hi, conider he derivaive of he valuaion expreion (3.2) wih repec o ime, : ρ (1 c)(1 λ (3.6) V = 1 ( X + B i (1 τ ) B ) V p) µ 1 λ p & + & If he firm finance all of i operaion by borrowing, hen i keep i equiy value exacly a zero, i.e., V V& = 0. In hi cae, he equilibrium valuaion condiion (3.6) become = (3.7) i ( 1 τ ) B = X + B&, 9 For a mulinaional corporaion, addiional limi may apply. In he Unied Sae, for example, only a porion of he inere on domeic borrowing may be ued o offe domeic ource income. See Froo and Hine (1995). 26

29 which ay ha he reurn o deb equal he firm real ne cah flow, X, plu he addiional amoun of deb he firm i able o iue wihou reducing i equiy value, i.e., he increae in he value of he firm. Bu hi i imply he firm economic income, ay E, le axe compued before inere deducion, τe. Thu, we may rewrie (3.7) a: (3.8) i (1 τ ) B = E τe from which i follow ha inere paymen will be le han, greaer han, or equal o EBIT, E, according o wheher E i le han, greaer han, or equal o economic income, E. Indeed, if economic income and EBIT are equal, hen we may cancel he corporae ax rae τ from boh ide of (3.8), meaning ha he pah of he firm deb, and hence i value, i independen of he corporae income ax (Samuelon 1964). In general, hough, he corporae ax bae deviae from rue economic income, a corporae ax yem rea cerain ype of income uch a corporae capial gain favorably, hereby lowering he value of E. The ame effec i provided by cheme ha provide generou deducion for oher corporae expene, noably depreciaion. Hence, corporaion may well hi he limi of curren deducibiliy a coniderably le han an all-deb capial rucure, even before accoun i aken of he fac ha ex po reurn are riky and may fall hor of heir cerainy-equivalen value. Taking rik ino accoun, he ax yem aymmery decribed in (3.5) will impoe a greaer diincenive o borrow on firm wih more uncerain reurn. The reuling financial equilibrium, hen, will be one in which he equaliy (3.4) i eablihed by he endogeneiy of he corporae ax rae. The auory ax rae τ i replaced in he equaion by a funcion of τ and τ* ha ake ino accoun boh he likelihood ha he firm will no be able o deduc marginal inere paymen immediaely and he value of uch deferred 27

30 deducion. Thi equilibrium, of coure, will alo be affeced by he rik and ax characeriic of he ae in which he firm inve. The iuaion preen he firm wih a rade-off beween inere deducion and oher ax deducion, a explored iniially by DeAngelo and Mauli (1980) and analyzed in more deail by Sinn (1987). While, ceeri paribu, firm would generally eek o maximize oher deducion, hey may no do o if here are direc co involved (a hrough a diorion of invemen deciion) or if here are oher advanage o borrowing, uch a monioring ha deb-holder may provide (Kanniainen and Söderen 1994) The Miller equilibrium For many ax yem, he corporae ax rae i well above he average marginal ax rae on inere income. In he Unied Sae, he corporae ax rae a he urn of he cenury wa 35 percen, while he highe marginal ax rae (ubjec o mall furher adjumen) wa 39.6 percen. Wih a ubanial hare of ae held by ax exemp iniuion uch a penion fund, for whom only he corporae ax on equiy income applie, i eem clear ha he ypical inveor would face a lower oal ax burden on deb han on equiy. Bu, a elaboraed by Miller (1977), how one define he relevan marginal inveor depend on he naure of financial equilibrium. In a world in which inveor chooe o hold only deb or only equiy according o which yield a higher afer-ax reurn, all ha i neceary for an inerior oluion i ha here exi ome inveor who prefer equiy (and ome who prefer deb) for ax purpoe. Thi equilibrium i illuraed in Figure 3.2, which plo he relaive 10 Kanniainen and Söderen derive heir reul in he conex of a model in which firm face he one-book accouning conrain ued by ome counrie, in which dividend can be paid only ou of axable earning. In hi model, an increae in non-inere ax deducion require a reducion in dividend and hence in borrowing. Furher dicuion of he implicaion of one-book accouning on financial deciion and he co of capial may be found in 28

31 peronal ax preference for deb, defined by he raio 1 ψ ( y), a a funcion of income, y, along 1 φ ( y) wih he corporae ax preference for equiy, 1-τ (which i independen of an individual income). If marginal ax rae increae wih income, and he individual ax on equiy, φ, i ome fracion of he ax rae on deb, ψ, he ax preference for deb will be decreaing in y, a hown in he figure. A income level y*, he wo curve cro and expreion (3.4) i aified. Clearly, if all inveor had income y*, deb and equiy would be equally preferred and firm indifferen in equilibrium. Bu even wih a range of inveor wih income below and above y*, here will ill exi an equilibrium in which equiy and deb coexi and firm are indifferen beween hem. Firm indifference alone doe no require ha (3.4) hold, merely ha he required reurn o equiy, ρ, equal he afer-ax inere rae i(1-τ). Auming hi condiion o be me, we can ee ha hoe for whom y > y* will receive a higher reurn from holding equiy han from holding deb, and hoe for whom y < y* will receive a higher reurn from holding deb han from holding equiy. Thu, if individual may hold only poiive quaniie of eiher ae, hen he marke for deb and equiy will clear if firm who are indifferen wih repec o heir individual deb-equiy choice iue ju enough deb o aify he demand of hoe wih income below y*. Hence, only he aggregae deb-equiy raio, and no ha of any firm, will have a deerminae oluion. Thi heory characerize he marginal inveor no a ome repreenaive inveor, bu raher a he inveor who i indifferen from a ax perpecive beween deb and equiy. Thu, if he ax yem change, he ideniy of he repreenaive inveor will change, oo. For example, if he ax yem hif in favor of equiy (a would be he cae if individual ax rae roe) hen, Kanniainen and Söderen (1995). Alo ee Sørenen (1994), who provide an inegraed dicuion of hi conrain and hoe underlying he equiy policy regime dicued above. 29

32 a illuraed by he dahed chedule in Figure 3.2, he marginal inveor would become omeone wih lower income, y**, and he aggregae corporae deb-equiy raio would fall. The Miller model i eaily generalized o he cae of more han wo ype of ae, for example wih he addiion of compleely ax exemp municipal bond in which he very highe bracke individual would pecialize. Bu he model confron a more eriou limiaion, namely ha i predicion of inveor pecializaion i paenly fale. In he real world, even non-axable penion fund hold a ubanial hare of heir ae in he form of equiy. Thi conradicion arie becaue he Miller model preume ha ae differ wih repec o ax reamen alone, o ha here i no rade-off wih repec o oher characeriic. In a more general model in which deb and equiy differ wih repec o rik a well, Auerbach and King (1983) howed ha he Miller reul generally require he ae pace o be ufficienly complee o permi ax panning ha le houehold chooe reurn paern and ax reamen eparaely. Oherwie, houehold will hold porfolio diverified wih regard no only o individual equiy holding, bu alo wih regard o deb and equiy. 11 Wih uch diverificaion come a redefiniion of he marginal inveor. Now, he ax rae of all inveor holding boh deb and equiy maer in he calculaion, enering in a weighed average. The weigh depend on he degree of abolue rik averion, he le rik-avere individual 12 in a beer poiion o arbirage difference in rae of reurn playing a more powerful role. 11 In hi chaper in hi Handbook, Poerba conider he porfolio-choice implicaion of he Auerbach-King model in more deail. 12 Wih well-behaved preference oward rik characerized by declining abolue rik averion, individual weigh would be increaing no only wih repec o rik olerance, given wealh, bu alo wih repec o wealh. 30

33 3.3. Evidence on he effec of axaion on corporae borrowing One eemingly obviou approach o evaluaing wheher ax rule favor borrowing i o eimae he impac of change in deb on firm value. However, a lile hough reveal why uch an approach i unlikely o ucceed. Becaue he change in a firm deb doe no reul from a random proce, he marke repone reflec no only i valuaion of he change ielf, bu alo whaever informaion he change convey. A noed by Fama and French (1998), hee effec are difficul o eparae. Moreover, even if adequae conrol for informaion effec did exi, valuaion repone would merely reveal he preence of deviaion from opimal policie, raher han he underlying influence of axe. Tha i, for any model in which firm evenually ele a an inerior opimum, eiher becaue marginal ax benefi decline or marginal non-ax co increae, he marginal impac on value of a change in deb hould be zero. Poiive repone o increae in deb would ugge ha firm had iniially eled on deb-equiy raio ha were oo low, and negaive repone would ugge ha iniial deb-equiy raio were oo high, wih neiher oucome revealing anyhing abou he ize of he ax benefi a any given level of borrowing. While he pure Miller model would predic no valuaion repone (conrolling for informaion effec) becaue opimal firm policy i indeerminae, he lack of a meaured repone migh alo imply reflec ha firm, on average, are a heir repecive unique opima. Such an exercie, hen, migh hed ligh on wheher manager ac in he inere of hareholder, raher han elling u much abou he ax benefi of leverage. Mo empirical inveigaion of he imporance of ax rule wih repec o he choice of financial rucure may be claified ino wo main caegorie. The fir group of udie eimae he exen o which inere paymen are ax deducible, hedding ligh on he poenial imporance of compeing ax hield a an explanaion of limied borrowing. The econd 31

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