Taxation, Corporate Capital Structure, and Financial Distress

Abstract

Is corporate leverage excessive? Is the tax code distorting corporate capital structure decisions in a way that increases the possibility of an economic crisis owing to "financial instability"? Answering these kinds of questions first requires some precision in terminology. In this paper, we describe the cases for and against the trend toward high leverage, and evaluate the role played by taxation. While provision of proper incentives to managers may in part underlie the trend to the debt, high leverage may in practice be a blunt way to address the problem, and one which opens up the possibility for undue exposure to the risks of financial distress.