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Are Higher Taxes For Corporations Actually Increasing Risk in the Economy?

Flickr / RCB.

Corporate capital structure theory (yes, there is such a thing) suggests that companies would be better off by borrowing more when taxes are high because leverage comes with tax benefits. But it's been hard to figure out if this is true in the real world -- until now.

A recent study looking at nearly a century of corporate data has found that higher taxes on corporations tends to beget higher leverage. Does this mean that a presumably beneficial policy is actually introducing more risk into the economy?

How corporate taxes increase leverage 
The study's authors looked at tax returns, leverage rates, and tax law changes between 1926 and 2009. They found that leverage rates have increased quite steadily through the last century "from a low of 51.65% in 1931 to a high of 75.15% in 1978." In 2009, the average leverage ratio was 63.77%.

As suspected, corporate tax rates are very predictive of leverage except in the smallest corporations, which don't have the same access to capital markets as large ones. On average, increasing the corporate tax rate by 1% increases leverage by 0.18%. In doesn't sound like much, until you look at the numbers: In 2009, these changes amount to $137 billion more in leverage versus only $8 billion more in tax revenue. 

In other words, increases taxes a little bit increases leverage a lot.

The relationship is particularly true for large companies, which respond quite swiftly to tax changes.

Does it introduce risk to the economy? 
The question of an optimal leverage ratio isn't perfectly straightforward: These things obviously depend on the company, the industry, and a number of other factors. 

At the same time, we do know that more leverage is riskier for companies. With a higher debt burden, a company won't be as flexible in adapting to shocks like a sudden economic crisis. Thus, too much leverage can make a company more susceptible to default or crisis. Whatever your stance on a particular company's leverage ratio, it's one of many risk factors that you might look for if you want to invest, and it's a key part of establishing a company's overall risk profile. 

What's the solution -- and do we need one? 
Surely leverage is not a bad thing in and of itself, but in excess it can be detrimental -- as the old saying goes, too much medicine can make a poison. 

Those against taxation might respond to a study like this by saying that it proves taxes should be lower. After all, lower taxes means less leverage and thus less risk in the economy. 

But you could also argue that perhaps the tax benefits of leverage should be reduced instead. Why are we encouraging something that has been shown, at least in excess, to be bad for us? Or should government simply try to focus on reducing the credit bubbles and booms that encourage too much borrowing, and leave capital structure to be what it will be? 

Whatever the answer, this paper shows that seemingly minor changes in policy can have large and unexpected results.

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Anna Wroblewska

Anna began her career in finance as a college intern at a hedge fund, and she hasn’t been able to escape its siren song ever since. She’s done academic research at Harvard Business School and UCLA, was the COO of a wealth management firm, and now writes about finance, economics, behavior, and business.

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