Taxation, Corporate Capital Structure, and Financial Distress
Mark L. Gertler
R. Glenn Hubbard
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
Our story takes as given the kinds of managerial incentive problems deemed
important by advocates of leverage. We maintain, however, that when a firm is
subject to business-cycle risk as well as individual risk, a profit maximizing
arrangement is not simple debt, but rather a contract with mixed debt and
equity features. That is, the contract should index the principal obligation
to aggregate and/or industry-level economic conditions.
We argue that the tax system encourages corporations to absorb more businesscycle
risk than they would otherwise. It does so in two respects: First, it
provides a relative subsidy to debt finance; second, it restricts debt for tax
purposes from indexing the principal to common disturbances. At a deeper
level, the issue hinges on the institutional aspects of debt renegotiation. If
renegotiation were costless, then debt implicitly would have the equity
features relevant for responding to business-cycle risk. However, because of
the diffuse ownership pattern of much of the newly issued debt and also because
of certain legal restrictions, renegotiation is likely to be a costly activity.
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