As Certain as Debt and Taxes: Estimating the Tax Sensitivity of Leverage from Exogenous State Tax Changes

Abstract

We use a natural experiment in the form of staggered changes in corporate income tax rates across U.S. states to show that tax considerations are a first-order determinant of firms’ capital structure choices. Over the period 1990-2011, firms increase long-term leverage by 116 basis points on average (equivalent to $59.4 million in extra debt) when their home state raises tax rates. Contrary to standard trade-off theory, the tax sensitivity of leverage is asymmetric: Firms do not reduce leverage in response to tax cuts. Using treatment reversals, we find this to be true even within-firm: Tax increases that are later reversed nonetheless lead to permanent increases in a firm’s leverage – an unexpected and novel form of hysteresis. Our findings are robust to various confounds such as unobserved variation in local business conditions or investment opportunities, union power, or states’ political leanings. Treatment effects are heterogeneous: Tax sensitivity is greater among profitable and investment-grade firms which respectively have a greater marginal tax benefit and lower marginal cost of issuing debt.