Debt and Creative Destruction: Why Could Subsidizing Corporate Debt Be Optimal?

Zhiguo He () and Gregor Matvos ()
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Gregor Matvos: University of Chicago Booth School of Business, Chicago, Illinois 60637; and National Bureau of Economic Research, Cambridge, Massachusetts 02138

Management Science, 2016, vol. 62, issue 2, 303-325

Abstract: The existing theoretical literature provides little justification for a corporate debt subsidy. We illustrate the welfare benefit of this subsidy and study how the social costs and benefits change with the duration of industry distress. In our model, two firms engage in socially wasteful competition for survival in a declining industry. Firms differ on two dimensions: exogenous productivity and endogenously chosen amount of debt financing, resulting in a two-dimensional war of attrition. Debt financing increases incentives to exit, which, although costly for the firm, is socially beneficial. These benefits decline as industry distress shortens. Our normative model sheds light on why the debt tax subsidy still persists around the world. Analogously, the model can also rationalize a seemingly ad hoc feature of the U.S. tax system, which subsidizes the conflict of interest between debt and equity regarding firm liquidation. This paper was accepted by Amit Seru, finance.

Keywords: war of attrition with asymmetric information; externality; endogenous types; debt tax shield; capital structure; tax policy (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (5)

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http://dx.doi.org/10.1287/mnsc.2014.2120 (application/pdf)

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Working Paper: Debt and Creative Destruction: Why Could Subsidizing Corporate Debt be Optimal? (2012)
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