John Graham
Duke University, Durham, NC 27708
ABSTRACT
The traditional view is that interest deductibility provides an important incentive encouraging firms to finance their operations with debt. Many have pointed out, however, that the corporate tax advantage to debt is offset to some degree at the personal level due to the taxation of interest income. This paper investigates the degree to which personal taxes affect corporate financing decisions. Using cross- sectional capital structure regressions and controlling for personal taxes, I find that debt usage is positively correlated with tax rates in each year 1980-1994, with significant coefficients in each of the 15 regressions. Firms also increased their use of debt in response to the Tax Reform Act of 1986 (which contained changes in the personal tax treatment of interest income that encouraged the use of debt). In 1994 the hypothetical "lowest tax rate firm" had a debt ratio of 17.7%, while the "highest tax rate firm" had 24.6% debt; if personal taxation of interest income were eliminated, the "highest tax rate firm" would have had a debt ratio of 26.0%. The results suggest that it is important to measure the personal tax penalty using firm-specific information.