Personal Taxes, Endogenous Default, and Corporate Bond Yield Spreads

Sheen X. Liu (), Howard Qi () and Chunchi Wu ()
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Sheen X. Liu: Williamson College of Business Administration, Youngstown State University, Youngstown, Ohio 44555
Howard Qi: Michigan Technological University, 1400 Townsend Drive, Houghon, Michigan 49931
Chunchi Wu: Lee Kong Chian School of Business, Singapore Management University, 50 Stamford Road, Singapore 178899, and School of Management, Syracuse University, Syracuse, New York 13244

Management Science, 2006, vol. 52, issue 6, 939-954

Abstract: Term structure models have often been criticized for failing to explain satisfactorily the yield spread between corporate and Treasury bonds. A potential problem is that the personal tax effect is ignored in these models. In this paper, we employ a structural model to investigate the role of personal taxes on both debt and equity returns in capital structure decisions and assess their impact on corporate bond yield spreads. It is shown that personal taxes affect the firm's optimal capital structure, and the tax premium explains a substantial portion of yield spreads, especially for high-grade bonds. The predictive ability of the model for yield spreads is much improved when personal tax effects are accounted for. In controlling for the liquidity effect, we obtain implied personal income tax rates closely in line with Graham's (1999) estimates.

Keywords: structural approach; endogenous default; personal taxes; yield spread; risk neutrality (search for similar items in EconPapers)
Date: 2006
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Citations: View citations in EconPapers (15)

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