Question

Assume that legislators are considering tax reform plan that will increase the corporate tax rate from 38.5% to 40% while noticing the tax deductibility of interest expenses. What effect would this tax reform plan have on optimal debt ratio of the corporations? Why? What is the tax deductibility of debt were removed?

Answer 1

Since interest is tax-deductible, increasing the tax rate would increase the deductible amount, and hence they would have to pay less taxes. This would support taking more debt on the Balance Sheet, so that more amount is deducted and the taxable income reduces. Hence, it will increase the optimal debt ratio for the firms.

If the tax deductibility of debt were removed, taking more debt would cause more interest to be paid. So, there will be no benefit of having debt on the balance sheet and firms would want to reduced the debt and might consider going to zero debt altogether.