Introduction
The taxation of corporate profits in the United States is a popular topic of discussion among public finance enthusiasts, mostly because corporate revenues are subject to double taxation. Double taxation involves the taxation of profits of the firm as an independent entity, as well as, the individuals after they have been awarded monies by the firm in the form of dividends, or following capital gains. The share of tax revenues from corporate gains has continuously declined from 21% in 1962 to 7.5% in 2003. “The Bush administration passed the Jobs and Growth Tax Relief Reconciliation Act of 2003 to minimize the taxation of corporate profits at the individual level” (Scholes, 2005); however, it did not impact on taxation at the corporate level. As a result, the issue of double taxation continues to be a key focus for financial debates. This paper looks at the impact of taxes on corporate capital structure.
Background
Studies show that the current tax system does not provide a favorable environment for business functions. Most businesses are discouraged from organizing as taxable corporations, and miss out in making proper decisions with regard to their communities due to the impact of double taxation (Scholes, 2005). According Scholes (2005), the existing tax system causes more harm to the wealth of the United States than the returns acquired. He claims that the state should result to an impartial tax system that does not influence the financial choices made by corporations, but, instead, promotes economic affairs. Conversely, supporters of the taxation system claim that corporate are independent entities that should be taxed separately from their shareholders. These supporters also claim that corporate taxes prevent individuals from avoiding taxation on their personal incomes (Rosen, 2002).
Studies on the effects of taxation on corporate operations show varying results though they hold that the tax system influences the decision making process of taxable firms. Studies by Gordon and Lee (2001) in the second half of the twentieth century sought to find out the impact of taxation on the economic guidelines of various corporations. The studies revealed that taxes have a huge impact on the use of debt, for all firms, irrespective of their size. The primary discussions concerning corporate taxation involve “who carries the burden of corporate tax – capital, labor or consumers, and its role in a progressive tax system; implications of the alterations caused by excess, corporate tax; and how the revenues raised from corporate tax can be replaced” (Gordon & Lee, 2001). This paper looks at studies done on the significance of distortions caused by excess, corporate tax, with emphasis on the impact of deductibility of interest on the capital structure of taxable corporations. This is achieved by evaluating the impact of debt financing and equity financing based on the analysis of tax incentives and the possibility of excess debt.
Corporate taxation
The subchapter of the Tax Code describes C corporations as legal entities that are capable of having numerous owners and a distinct management. Hence, most businesses seek to operate as C corporations in order to enjoy the financial benefits due to a large access to capital, as well as, enhanced potential for growth. Some of the benefits of corporations include broad access to capital through the sale of shares or bonds without interfering with company operations, great potential for growth, and limited liability. The effect of double taxation implies that corporations pay for the right to incorporate. However, some businesses avoid the system by conducting their operations as pass-through entities, which causes them to miss out on some of the benefits entitled to corporate. Pass-through entities include subchapter S corporations, sole proprietorships, and partnerships whose profits and losses are transferred to the owners (Brealey and Myers, 2000).
Corporations make their investments through equity or debt. “Equity involves any ready money that the firm has access including issue of stock while debt refers to money raised through borrowing from a variety of channels including shareholders, financial institutions, or from the public” (Brealey & Myers, 2000). The mode of financial access is one of the things that double taxation influences the corporate capital structure since corporations can opt to evade taxes by financing their operations through debt, instead of equity. However, studies show that corporations use huge amounts of equity capital. This is because there are some non-tax expenses that are incurred through debt financing including the typical costs of borrowing, and threat of financial distress posed by fixed liabilities due to challenges in making debt payments. Prolonged financial distress can result in bankruptcy, which means that the probability of financial distress is increased by increasing debt payment levels. This, in turn, magnifies the threat for the company’s defaulters, which causes them to claim greater return for their investment. As a result, there is an inverse relation between value of debt tax shields and the mentioned non-tax costs, such that a decrease of the former leads to a subsequent increase in the latter (Brealey & Myers, 2000).
In addition to non-tax costs, tax shield values are also influenced by the marginal tax rate of the firm, and the availability of non-debt tax shields and tax credits. Determination of the marginal tax rate varies depending on numerous factors including “estimated future earnings, the carry back and the carry forward provisions of the tax law, and the alternative minimum tax (AMT)” (Graham, 1996). According to Graham (1996), the correlation of “operating losses, marginal tax rates, and the value of tax shields fluctuates a lot, which makes it unpredictable”. For instance, corporations that forecast operating losses have no need for tax shields. Such firms use their net operating loss deductions (NOL’s) in the future to reimburse taxes paid today, which gives them a low marginal rate.
Corporations that have recorded negative returns in previous years and are expecting reasonable gains in subsequent financial years may apply NOL’s to minimize expected tax liability (Graham, 1996). “If such a firm carries back its present year NOL, which is less than or equal to its past liabilities, then the marginal tax rate of extra income presently earned will be equivalent to the pertinent statutory tax rate” (Graham, 1996). These instances prove the intricacies involved in the approximation of marginal tax rate of a corporate when NOL deductions are considered. Studies show that foreign tax credit restrictions minimize the value of debt tax shield. Additionally, they cause US multinationals to minimize their local debts by replacing them with equity financing (DeAngelo & Masulis, 1980).
Challenges of studies on corporate taxation
Financial analysts and authors encounter numerous challenges in the process of investigating the significance of taxation with regard to debt financing. The fist challenge involves concerns associated with the translation of technical information of the tax code in an appropriate manner that can reflect the merits of debt over equity financing. The previous methods used to find out the influence of interest deductions, tax rates and non-debt tax shields on carry-back and carry-forward prerequisites have been unsatisfactory due to their lack of access to relevant corporate tax return information. The second challenge involves the fluctuation of fiscal elements as seen in the inverse relation between decreasing tax benefits attributed to debt, and a converse increase in tax-weakening of corporations. The other challenge involves the intra and inter correlation of fiscal and non-fiscal elements, which worsens the variability of fiscal elements as stated in the previous constraint. Besides the three constraints mentioned, the borrowing of a corporation also depends on other factors pertaining to tax status.
Conclusion
Past empirical studies on the impact of taxation on corporate, financial policy were not as effective as recent studies, due to the inaccessibility of data in the past. However, recent studies revealed that the effect of taxation on financial policy of large corporations, towards the end of the twentieth century, was minimal. The studies showed that large firms employed debt financing for their assets 1.5% more than smaller firms. This marked a noteworthy decline when contrasted to similar studies in the past that revealed a margin of 9.1%. In conclusion, there exists a positive relationship between taxation and the use of debt financing. Taxes have a large impact on debt financing for larger firms, compared to intermediate firms that are impacted positively by the taxes. Equity financing can also be better placed than debt financing if the tax status of corporate investors is considered.
References
Brealey, R. A., & Myers, S. C. (2000). Principles of Corporate Finance, Sixth Edition. Irwin: McGraw-Hill.
DeAngelo, H., & Masulis, R. W. (1980). Optimal Capital Structure under Corporate and Personal Taxation. Journal of Financial Economics, 8(1), 3-29.
Gordon, R. H., & Lee, Y. (2001). Do Taxes Affect Corporate Debt Policy? Evidence from U.S. Corporate Tax Return Data. Journal of Public Economics, 82, 195-224.
Graham, J. R. (1996). Debt and the Marginal Tax Rate. Journal of Financial Economics, 41(1), 41-73.
Rosen, H. S. (2002). Public Finance, Sixth Edition. Irwin: McGraw-Hill.
Scholes, M. S., Wolfson, M. A., Erickson, M., Maydew, E. L., & Shevlin, T. (2005). Taxes and Business Strategy, a Planning Approach. Upper Saddle River, NJ: Prentice-Hall.