Three essays on the effects of taxation on corporate financial policy

This dissertation is composed of three essays aimed at examining the effects that the existing United States tax system has on the financial decisions made by firms. Corporate revenues are currently subject to double taxation. Profits are taxed first on the corporate level and then, when distributed as dividends or when capital gains are realized, taxed a second time on the individual level. Critics argue that the current tax system discourages business entities from organizing as taxable corporations and encourages corporations to veer from socially efficient decisions (Scholes et al. 2005, 336). The deductibility of interest expenses allowed by the tax system creates an incentive for corporations, when raising capital, to use debt instead of equity. Using confidential firm-level U.S. corporate tax return data this thesis studies how the deductibility of interest expenses affects the capital structure of taxable corporations. The first essay tests for the relation between a firm's tax status and its cumulative debt policy using data from a panel of corporate tax returns for the 8-year period form 1993 to 2000. The essay provides evidence of a positive relation between the debt-to-asset ratio and the tax status proxy for firms of all sizes. The second essay tests for the effects of taxation on the financial policy of closely held corporations by taking advantage of a number of legislative acts that affected the tax treatment of both taxable and S corporations. Using a difference-in-difference approach the work provides significant evidence that corporate taxation affects the financial policy of closely held taxable corporations. Finally, the third essay uses tax return data for the 1993 to 2002 period to estimate the amount of additional debt issued by firms due to taxation. Using two different tax incentive proxies, the work presents evidence that an increase in the marginal tax rate of taxable corporations by one percentage point will lead to, depending on the proxy for the tax incentive used, an increase in the growth rate of the interest paid deduction of 2 to 15 percent yearly.