Taxes Depress Corporate Borrowing: Evidence from Private Firms

Layer 1 — Overview

Research Question

Does corporate income taxation raise or lower corporate leverage? The canonical Modigliani-Miller (1963) view holds that the interest tax deduction makes debt more attractive, predicting a positive taxes-to-leverage relationship. Most prior empirical work using large public firms confirms this prediction. This paper re-examines the question using data on small private U.S. firms and finds the opposite: higher corporate taxes depress leverage, at least for small, financially constrained private firms.

Data and Identification

The primary dataset is the Federal Reserve’s Y-14Q supervisory collection (2011–2017), which covers the loan portfolios of the 33 largest U.S. banks and includes firm-level income statements and balance sheets for privately held, bank-dependent borrowers. The sample is restricted to domestic private C-corporations with prior-year assets above $100 million (to screen for pass-through entities), yielding 39,363 non-singleton firm-year observations. The median firm has $288 million in book assets and total debt-to-assets of approximately 38%. A supplementary dataset from the Shared National Credit (SNC) Program (1993–2018, 50,203 firm-year observations) provides a longer time series on syndicated loan commitments. Public firm comparisons use CRSP-Compustat (91,314 observations, 1989–2017).

The empirical strategy is a difference-in-differences event study using variation in state corporate income tax rates. A novel contribution is the manual collection of both enactment dates (when legislation was signed into law) and effective dates for each state tax change since 1975. Identification follows the narrative approach of Romer and Romer (2010) and Giroud and Rauh (2019) to exclude tax changes endogenous to local economic conditions. The specification includes firm and industry-by-year fixed effects, and the analysis uses heterogeneity-robust estimators (Borusyak et al. 2024; de Chaisemartin and D’Haultfoeuille 2020) to address staggered treatment timing.

Main Empirical Findings

For small private firms (below-median total assets, i.e., below $288 million), long-term debt-to-assets rises by approximately 4% in the year of tax cut enactment and remains elevated—at approximately 2%—four or more years later, indicating a permanent increase in leverage. This anticipation effect arises because firms respond to the law’s passage, not its effective date; results using effective dates are noisy and largely insignificant. The average tax cut during the sample period was 1.2 percentage points, representing approximately a 6% reduction in firms’ tax bills (given an average private-firm tax rate of 21%), and the implied leverage change of about 6% at year four is correspondingly large, consistent with a low-interest-rate environment in which small changes in marginal q translate into large investment and borrowing responses.

For large private firms (above-median assets), leverage shows no significant response to tax cuts in any event year. For public firms, evidence of any effect is scant, with at most transient significance and pre-trend issues that complicate interpretation.

Mechanism

The paper argues two tax-sensitive costs of debt offset the standard interest tax shield. First, a higher tax rate reduces after-tax profits, raising default probabilities and credit spreads endogenously; a tax cut thus lowers credit spreads and incentivizes more borrowing. Second, because external equity finance is either unavailable or very costly for small private firms, debt and capital are complements in financing investment: a tax cut raises the marginal product of capital, inducing firms to invest and borrow more. For small firms with low capital adjustment costs, this capital-debt complementarity dominates the direct loss of interest tax shield value. For large firms with high capital adjustment costs (estimated at nine times the small-firm value), investment responds sluggishly to tax changes, the complementarity effect is muted, and the traditional tax shield effect becomes relatively more important—producing the standard, slightly positive taxes-to-leverage relationship.

Bank-assessed default probabilities fall by 20–30 basis points (roughly a 10% decline from an average of approximately 2%) in the year of enactment or one year later for small borrowers, directly supporting the model’s credit spread mechanism.

Welfare Counterfactual

Removing the interest tax deduction from the estimated model (while retaining profit taxation and restricted equity access) causes leverage to fall from 0.36 to −0.26. Firms substitute into cash holdings, shrinking the capital stock. In equilibrium, hours worked rise, the real wage falls, and consumer welfare drops by approximately 1.8%. The interest deduction thus raises welfare in a second-best sense by offsetting other frictions that impede optimal capital accumulation.

Layer 2 — Q&A

Q1: Why do prior studies find a positive taxes-to-leverage relationship, and how does this paper differ?

Prior studies—including Titman and Wessels (1988), Heider and Ljungqvist (2015), and Faccio and Xu (2015)—predominantly use large public firms, for which the interest tax shield is the quantitatively dominant consideration. The present paper focuses on small private firms that face greater financial frictions (restricted equity access, higher default risk), in which two additional tax-sensitive costs of debt become quantitatively important. A further methodological difference from Heider and Ljungqvist (2015) is the use of firm fixed effects rather than first differences, which the authors argue is appropriate in a staggered DiD design.

Q2: Why use enactment dates rather than effective dates as the event?

Tax legislation is often signed into law one to two years before taking effect; in the sample of 125 tax packages since 1975, 33 became effective the following year and 13 became effective two or more years later. Firms that anticipate future tax changes will adjust leverage immediately upon enactment, not at the effective date. Results confirm this: event studies using enactment dates yield precise positive estimates for small firms (ranging from ~4% at year 0 to ~2% at year 4+), while results using effective dates are noisy and mostly insignificant. The paper therefore treats the enactment date as the economically relevant event and collects these dates as a novel contribution.

Q3: What is the economic magnitude of the leverage response for small private firms?

Small firms’ long-term debt-to-assets rises by almost 4% in the enactment year and remains elevated at approximately 2% four or more years after enactment, consistent with a permanent adjustment. The average tax cut during the period was 1.2 percentage points, representing roughly a 6% reduction in the average tax bill (given an average effective rate of 21% for private firms, per Zwick et al. 2016). The estimated coefficient of 0.021 in year four also implies approximately a 6% change in leverage, a large response that the paper attributes to the low interest rate environment amplifying the marginal q effect of even modest tax changes.

Q4: Do large private firms respond differently to tax cuts, and why?

Large private firms (above the median of $288 million in total assets) show no statistically significant leverage response to tax cuts in any event year, and this null is not attributable to wider confidence intervals. The model estimation explains this via capital adjustment costs: the adjustment cost parameter for large firms is estimated to be nine times larger than for small firms. With high adjustment costs, investment responds sluggishly to a tax cut, so the complementarity channel (more investment requires more debt) is suppressed. The traditional tax shield effect then becomes relatively more important, producing a slightly positive (or zero net) taxes-to-leverage relationship consistent with the large-firm data moment.

Q5: How does the model generate a negative relationship between taxes and leverage when the interest tax deduction is present?

Two mechanisms offset the tax shield. First, higher taxes reduce after-tax profits, pushing firms closer to the default threshold; this is capitalized into equilibrium credit spreads, raising the cost of debt. Specifically, for small firms, the model shows that once leverage exceeds approximately 0.47 of assets, the after-tax risky interest rate rises monotonically with the tax rate (rather than falling via the deduction effect). Second, capital and debt are complements in financing investment: because a tax cut raises the marginal product of capital, and because external equity is unavailable, firms substitute into capital by using more leverage. For small firms with low capital adjustment costs, both mechanisms outweigh the loss of interest tax shield value when taxes fall.

Q6: How are the model parameters estimated, and what are the key parameter values?

The model is estimated by simulated method of moments on the Y-14 small-firm sample, minimizing the distance between nine data moments and their model-simulated counterparts. The nine moments include the means and standard deviations of debt, investment, and operating income (all as ratios of assets), the serial correlations of investment and operating income, and the coefficient from a two-way fixed-effects regression of leverage on a tax-change dummy. The deadweight loss in default (ξ) is estimated at 0.6 for small firms and 0.32 for large firms, consistent with elevated financial frictions for small firms and in line with average recovery rates in Kermani and Ma (2023). Fixed operating costs (f) are approximately 0.15 for both samples, amounting to just under half of steady-state operating profits. The serial correlation of the tax process is estimated at 0.662, with innovation standard deviation of 0.022.

Q7: What is the model’s welfare counterfactual, and what does it imply?

The paper compares two economies both with profit taxation: one with the interest tax deduction and one without. Removing the deduction in the small-firm model causes leverage to fall from 0.36 to −0.26, as firms hold net cash rather than net debt. The capital stock shrinks, output falls, hours worked rise, and both the real wage and consumption decline. Consumer welfare drops by approximately 1.8%. Capital misallocation (measured following Hsieh and Klenow 2009) worsens from 0.89 to 0.88. The result has a second-best character: the interest deduction incentivizes debt-financed investment that partially offsets the distortion from restricted equity access.

Q8: What does the evidence on default probabilities add to the empirical case?

The Y-14 collection contains bank-assessed default probability estimates. In an event study covering Q1 2012–Q4 2018, the authors find that firms’ assessed default probabilities decline significantly by 20–30 basis points in the year of enactment or one year later for small borrowers (those with total loan commitments of $10–$100 million), representing approximately a 10% decline from the sample average default rate of around 2%. This decline peaks two years after enactment and persists for three years. No comparable decline is observed for larger loan size buckets. Separately, in SNC data, the probability of a non-pass (i.e., below-investment-grade supervisory) rating falls by 1.7–2.2 percentage points following tax cut enactments, persisting roughly three years. Together, these findings directly validate the model mechanism by which tax cuts lower default risk and credit spreads.

Q9: Are the results robust to alternative econometric methods that address heterogeneous treatment effects?

Yes. The paper applies the Borusyak et al. (2024) imputation estimator, which imputes fixed effects from untreated observations onto treated observations to remove negative weighting bias; for small firms and event years 0–3, it finds significant positive estimates comparable to the baseline. The de Chaisemartin and D’Haultfoeuille (2020, 2021) estimator, based solely on first-time switchers to treatment, yields an effect of 0.036 on leverage for small firms in the enactment year and no effect for large firms, consistent with the baseline. Results using the narrative approach (excluding Connecticut 2011 and 2015, New York 2014, and Rhode Island 2014 as potentially endogenous) produce slightly larger leverage estimates.

Q10: Are tax hike effects symmetric to tax cut effects?

Evidence on hikes is weaker because tax hikes are rare in the sample. In Y-14 data, hikes are associated with leverage declines for small firms in event year 4 and for large firms in event years 1, 2, and 4, but without sufficient pre-hike observations to identify pre-trends, these results are less credible than the cut results. In SNC data (which spans a longer period, 1992–2018), tax hikes are associated with large and significant reductions in total syndicated borrowing commitments of 6–7%, while cuts produce smaller and marginally significant increases. This asymmetry is consistent with the lower adjustment costs of reducing debt relative to increasing it.

Q11: What does the analysis of alternative model specifications reveal about the generality of the mechanism?

Three model extensions are considered. In a collateral-constrained model (no endogenous default), the cost of debt is lost financial flexibility (the future shadow cost of the borrowing constraint), which remains tax-sensitive. In a model with costly equity issuance (linear cost λ = 0.11 following Hennessy and Whited 2007), equity issuance is rare, so the model behaves nearly identically to the baseline. In a solvency-based default model (default when firm value turns negative rather than when liquidity is insufficient), the negative taxes-to-leverage result is preserved. A news-shock extension (Jaimovich-Rebelo 2009) incorporating the anticipation of future tax changes also produces lower leverage in response to higher anticipated taxes, consistent with the empirical anticipation effects, though with smaller magnitudes because the news shock variance is smaller than the total tax-change variance.

Q12: Why do contingent-claims models (Fischer-Leland-Goldstein class) always predict a positive taxes-to-leverage relationship?

In these models, shareholders have deep pockets, so negative cash flows can always be covered; this implies default is rare and the effect of taxes on the default put value is small relative to the direct interest tax deduction. Additionally, these models contain no capital stock, so there is no substitution mechanism between capital and a storage technology (i.e., cash/negative debt). Without endogenous investment, the only channel linking taxes to leverage is the tax shield, which necessarily implies a positive taxes-to-leverage relationship. This is why, as the paper notes, the result was “already hiding” in the Hennessy-Whited class of dynamic investment models but not visible in the contingent-claims literature.

Key Concepts

Interest Tax Deduction (Tax Shield) The paper uses this in the standard corporate finance sense: the after-tax cost of debt is reduced because interest payments are deductible against corporate income. In the model, debt proceeds are discounted at the after-tax interest rate, and the deduction is taken at the time of debt issuance. The paper’s contribution is to show this benefit can be outweighed by two tax-sensitive costs of debt, reversing the sign of the taxes-to-leverage relationship for small, constrained firms.

Tax-Sensitive Cost of Debt The paper defines two distinct tax-sensitive costs that offset the tax shield. First, taxes reduce after-tax profits, shifting the default threshold and raising equilibrium credit spreads; this is capitalized into the risky lending rate endogenously from the lender’s zero-profit condition. Second, taxes reduce the marginal product of capital, making debt-financed investment less attractive; because debt and capital are complements in a model without external equity, a higher tax rate lowers optimal capital and, with it, optimal debt.

Capital Adjustment Costs (ψ) Quadratic costs of changing the capital stock, parameterized as ψ(k’ − (1−δ)k)² / (2k). The paper identifies this parameter as the key determinant of whether leverage responds positively or negatively to taxes: for small firms, ψ is estimated to be near zero (insignificantly different from zero), enabling free substitution between capital and the storage technology (negative debt), so the complementarity channel dominates. For large firms, ψ is estimated to be nine times larger, suppressing this substitution.

Default Threshold In the model, default is triggered when the firm’s current after-tax profits plus recoverable capital are insufficient to repay debt: (1−τ)(y − wn − f) + (1−ξ)(1−δ)k < p. This threshold depends directly on the tax rate τ, so higher taxes move the threshold in the direction of default, raising credit spreads. The paper provides empirical support for this mechanism via the event study of bank-assessed default probabilities.

Enactment Date vs. Effective Date The paper distinguishes between the date tax legislation is signed into law (enactment date) and the date it becomes operative (effective date), which can differ by one to two years. The paper collects novel data on enactment dates from state legislative records. The empirical finding that firms respond to enactment rather than effective dates constitutes evidence of anticipation effects: firms adjust leverage upon observing future expected tax changes, not when the changes actually take hold.

Second-Best Welfare Effect of the Tax Deduction The paper uses this term to characterize the welfare result from the counterfactual: in an economy already distorted by profit taxation and restricted equity access, the interest deduction raises consumer welfare by incentivizing debt-financed capital accumulation. Removing the deduction causes firms to substitute into cash, shrinking the capital stock and lowering wages and consumption. This is a second-best result because the deduction is welfare-improving only because it partially offsets the distortions created by other frictions; in a frictionless world, no such second-best rationale would apply.

Y-14Q Supervisory Data The Federal Reserve’s supervisory collection from the 33 largest U.S. banks, covering loan portfolios and associated borrower financial statements for firms with commercial and industrial loans exceeding $1 million in commitment. The paper uses this dataset because it covers private, bank-dependent firms—a population not previously studied in the tax-leverage literature—and contains firm-level balance sheets, credit ratings, and default probability estimates.