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Taxation and the optimal constraint on corporate debt finance: why a comprehensive business income tax is suboptimal

Peter Birch Sørensen ()
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Peter Birch Sørensen: University of Copenhagen

International Tax and Public Finance, 2017, vol. 24, issue 5, 731-753

Abstract: Abstract 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.

Keywords: Tax bias against equity finance; Optimal constraint on debt finance (search for similar items in EconPapers)
JEL-codes: H21 H25 (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:kap:itaxpf:v:24:y:2017:i:5:d:10.1007_s10797-016-9432-1