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The Impact of the Tax Benefits of Debt in the Capital Structure of Firms and the Stability

of the Financial System

30 Mar 2017

In a seminal work, Modigliani and Miller pointed out that, in a world with no asymmetries
of information, no transaction costs, no taxes and no costs of bankruptcy, the value of
the firm is independent of its capital structure. Nevertheless, subsequent studies
showed that, once these ‘market frictions’ are included in the model, the use of debt
may maximize the value of the firm or, at least, it would be preferred by the

First, the use of debt may reduce agency costs between managers and shareholders.
On the one hand, the existence of debt reduces the amount of free cash flows that
managers may waste when running the firm (Jensen, 1986). On the other hand, the
use of debt will encourage creditors (especially if they are professional lenders) to
monitor the debtor´s activities.

Second, the use of debt may generate a positive signal to the market in a world (as
ours) of asymmetries of information. As stated by the pecking order theory, mainly
popularized by Myers and Majluf, companies prefer to use debt over equity due to the
asymmetries of information existing between insiders (i.e., managers and controlling
shareholders) and outsiders (ie, minority shareholders and creditors). Indeed, if insiders
knew that the company is not going to generate enough cash-flows to repay its debts,
they would likely prefer to use equity over debt, since equity does not imply a fixed
payment that may put the company´s solvency at risk. Therefore, managers will have
incentives to prefer equity over debt when they are not confident about the performance
of the company and its future ability to generate cash-flows. Otherwise, they may end
up losing their jobs (in the case of managers) or their investments (in the case of
controlling shareholders). Based on this assumption, then, if the managers finally decide
to use debt, the market may perceive this choice as a ‘bet’ made by the insiders on their
own firm. For this reason, the use of debt may generate a positive signaling effect on
the market.
Third, the use of debt is less expensive than the use of equity because debt is generally
subsidized by the state through the tax system –since debtors can deduct the interest
payment associated with the use of debt. Therefore, the use of debt may reduce the
firm´s cost of capital. Fourth, borrowing money does not require the costly procedure
generally existing in many countries to increase capital. Fifth, to the extent that a
company´s cost of debt is lower than the company´s returns on assets (ROA), the
shareholders will prefer to borrow money. Thus, they can increase their returns (ROE)
without making new investments. Finally, the use of debt also externalizes the risk of
bankruptcy to third parties. Therefore, shareholders will also have incentives to prefer
debt over equity. For all of these reasons, firms will usually prefer the use of debt over
equity, at least up to certain limits –as shown by the trade-off theory.

From a policy perspective, though, since the use of debt increases a company´s risk of
insolvency, and insolvency may generate several costs for society (especially in the
context of financial institutions), many jurisdictions encourage or even impose a certain
amount of equity. For non-financial firms, these capital requirements usually depend on
the jurisdiction. Common law countries (and more recently some civil law countries
especially in Latin America) do not usually impose many rules regarding minimum legal
capital. Many civil law jurisdictions (especially in Continental Europe), however, do
impose several rules regarding minimum capital, capital maintenance or even the
liability of directors for the company´s debts when the managers fail to file for either
bankruptcy or dissolution (unless the company increases capital) whenever the
company´s assets fall below a certain amount of the legal capital.

The case for maintaining a certain level of minimum capital becomes even more
important in the context of financial institutions, since the cost of a bank failure is not
only borne by the shareholders and the creditors but also by taxpayers (if there is a
bailout) and/or, more generally, by society as a whole (due to the negative externalities
potentially generated by a bank failure). Therefore, financial institutions are subject to
higher capital requirements, especially after the new recommendations of the Basel
It seems paradoxical, however, that, while corporate and financial regulators seem to be
aware of the potential costs borne by third parties in a situation of financial distress, and
this explains many rules imposing capital requirements, the tax system
actually incentivizes the use of debt –ie, tax codes incentive firms to increase their risk
of insolvency. In my opinion, there are no convincing reasons to favor debt over equity
through the tax system. In fact, as the process to increase capital is more costly than
borrowing money (especially in some civil law countries, where raising capital usually
requires shareholder approval, a change in the bylaws, the intervention of a public
notary, the payment of taxes, etc), and the use of debt may create some negative
externalities, equity should even have a better tax treatment than debt.

Moreover, in the specific context of financial institutions, several studies have shown
that higher capital requirements for financial institutions may hamper people´s access to
finance (Aiyar, Calomiris, Wieladek, 2012; Remolina, 2016). And this consequence
could be particularly harmful for emerging economies, due to their greater problems of
financial exclusion (Remolina, 2016). Likewise, for non-financial firms, rules regarding
minimum capital and capital maintenance may also be inefficient, since they do not
generate a clear gain while they may generate several costs (Armour, 2006; Enriques
and Macey, 2001). And the liability of directors for failing to file for either bankruptcy or
dissolution (unless the company increases capital) whenever the company´s net assets
fall below a certain amount of legal capital may also discourage innovation and
entrepreneurship, since many companies reporting losses at an early stage of their
business may be incentivized to leave the market (Gurrea, 2016).

In my recent paper, entitled “The impact of the tax benefits of debt in the capital
structure of firm and the stability of the financial system” (available in Spanish), I argue
that a simple change in the tax system may promote a more efficient capitalization of
firms –if this is the goal potentially wanted by corporate and financial regulators.
Namely, I propose to implement a tax reform in which companies may deduct an
implied interest of equity, as it was adopted in Belgium in 2006. Thus, as the ‘Belgium
experiment’ seems to prove, both financial and non-financial firms will likely increase
their level of equity in a more natural and efficient way. Likewise, as it has been
suggested by various authors, including Admati (2014), Roe and Troege (2016), and
a group of prominent finance scholars, I also argue that the tax benefits of debt should
be abolished in the context of financial institutions. By implementing these simple
changes in a national tax code, legislators could promote the capitalization of firms
(including banks) and the stability of the financial system in a more efficient way than
the costly rules imposed by the Basel Committee and many corporate laws around the