TY - JOUR
T1 - Taxation and the optimal constraint on corporate debt finance
T2 - Why a comprehensive business income tax is suboptimal
AU - Sørensen, Peter Birch
PY - 2017/9/1
Y1 - 2017/9/1
N2 - The tax bias in favour of debt finance under the corporate income tax means that corporate debt ratios exceed the socially optimal level. This creates a rationale for a general thin capitalization rule limiting the amount of debt that qualifies for interest deductibility. This paper sets up a model of corporate finance and investment in a small open economy to identify the optimal constraint on tax-favoured debt finance, assuming that a given amount of revenue has to be raised from the corporate income tax. For plausible parameter values, the socially optimal debt-asset ratio is 2–3% points below the average corporate debt level currently observed. Driving the actual debt ratio down to this level through limitations on interest deductibility would generate a total welfare gain of about 5% of corporate tax revenue. The welfare gain would arise mainly from a fall in the social risks associated with corporate investment, but also from the cut in the corporate tax rate made possible by a broader corporate tax base.
AB - The tax bias in favour of debt finance under the corporate income tax means that corporate debt ratios exceed the socially optimal level. This creates a rationale for a general thin capitalization rule limiting the amount of debt that qualifies for interest deductibility. This paper sets up a model of corporate finance and investment in a small open economy to identify the optimal constraint on tax-favoured debt finance, assuming that a given amount of revenue has to be raised from the corporate income tax. For plausible parameter values, the socially optimal debt-asset ratio is 2–3% points below the average corporate debt level currently observed. Driving the actual debt ratio down to this level through limitations on interest deductibility would generate a total welfare gain of about 5% of corporate tax revenue. The welfare gain would arise mainly from a fall in the social risks associated with corporate investment, but also from the cut in the corporate tax rate made possible by a broader corporate tax base.
U2 - 10.1007/s10797-016-9432-1
DO - 10.1007/s10797-016-9432-1
M3 - Journal article
SN - 0927-5940
VL - 23
SP - 1
EP - 23
JO - International Tax and Public Finance
JF - International Tax and Public Finance
ER -