Financial leverage ; Debt ; Corporations - Finance ; Tax Reform Act of 1986 ; Taxation

Frederick T. Furlong

English

Research Papers in Economics

FRBSF WEEKLY LETTE8
November 24, 1989
Corporate Debt
In recent years, nonfinancial corporations have
expanded debt and retired equity. This trend
towards increased debt has raised concerns that
U.S. firms are becoming more vulnerable to an
economic downturn. The well-publicized prob-
lems of specific highly-leveraged corporations
have added to this concern, and have led to
increases in interest rates on speculative-grade,
or junk bonds, which should limit issuance of
this type ofdebt. For most corporations, however,
the trend in debt issuance could continue, given
the way u.s. tax laws favor debt over equity. One
change in the tax laws that would redress some
ofthis imbalance is a reduction in the tax
on capital gains proposed by the Bush
Administration.
Taxes and debt
u.s. tax policy generally favors the use of debt
over equity financing by corporations. Owners
of corporate stock in effect pay taxes on profits
twice, once when the corporation pays taxes
on its earnings and again when individuals pay
taxes on dividends or capital gains. In contrast,
interest on debt is a tax-deductible expense-for
businesses, and so, is taxed only once, as
ordinary income to debt holders.
Tax considerations are not the only factors
affecting a firm's leverage, or debt/equity mix.
For example, the higher risk associated with
heavy reliance on debt (relative to equity) tends
to limit corporate leverage. By increasing the
probability that a firm will not be able to meet
promised payments, increased reliance on debt
raises expected bankruptcy costs. Because debt
holders require compensation for this increased
risk, the cost of issuing debt should rise and off-
set tax benefits (and other factors) favoring debt
financing.
In the long run, corporations can be expected
to operate with a debt/equity mix that balances
these and many other influences. Changes in the
tax code that increase the tax advantage of debt
financing, then, alter this balance and encourage
corporations to increase leverage and realign
their debt/equity mix.
The most recent rnajbr change in tax policy
affecting the debt-related bias in tax policy was
the 1986 Tax Act. By reducing the. marginal tax
rate on ordinary income (from 50% to 33%) and
raising the maximum marginal tax rate on capital
gains (from 20% to 33%), the Act increased the
tax burden on equity income relative to that on
interest income. The Act also reduced the max-
imum corporate tax rate from 46 to 34 percent,
thereby diminishing to some extent the tax
advantage of debt financing.
Analysts differ over the net effects of the Tax Act.
Part of the controversy turns on which taxpayers'
marginal tax rates are relevant for determining
the balance between corporate debt and equity.
The perspective taken here is that the maximum
marginal tax rates are the appropriate measures.
Given this perspective, the changes in tax rates
following enactment of the 1986 Act likely have
increased the bias in U.s. tax policy toward debt.
This is because the reduction in the corporate tax
rate was not enough tooffset fully the changes
in the maximum rates on ordinary income and
capital gains.
Increase in leverage
To illustrate how much the Tax Act may have
affected corporate leverage, a statistical model
was used to predict the aggregate market-value
debt/equity (DIE) ratio for nonfinancial corpora-
tions with and without the tax law changes that
went into effect after 1986. This model assumes
that changes in the maximum marginal tax rates
on corporate earnings, ordinary income, and
capital gains, as well as expected returns,
expected inflation, and uncertainty, affect
the relative attractiveness of debt and equity
financing, and thereby cause movements in
the aggregate DIE ratio.
Chart 1 compares the actual DIE ratio (solid line)
with the two predicted DIE ratios obtained from
the statistical model. The dashed line is the
predicted ratio based on actual tax rates, and the
dotted line is the aggregate DIE ratio that would
have occurred if tax rates had not changed
after 1986.FABSF
Market Portfolio
Standard
Deviation of Return
0.30
0.25
0.20
0.15
0.10
0.05
~"'-'--'--.--,~,......,....,...,.~,..,.,-~rr-r-'-+ 0.00
Chart 2:
Corporate Risk
(quarterly)
0~65
0.55
0.50
0.60
Debt/Equity
Ratio
0.70
1987 1986
Chart 1:
Effects of the 1986 Tax Act on
Market-Value Corporate Leverage
Predicted, without
1986 changes
r--~~~r---"~~---,~~~----r~~~-+ 0.45
1988 1989
Predicted values based on out·of·sample simulations.
As the chart shows, the actual DIE ratio rose
sharply and remained high following the stock
market crash in October 1987. Although the
dashed line does not capture all the movements
in the actual DIE ratio, it does capture the
general upward trend, suggesting that factors
other than the stock market crash also may have
influenced corporate leverage in recent years.
A comparison of the dashed and dotted lines
indicates that a large portion of the rise in the
DIE ratio may have been due to the 1986 Tax Act.
For the second quarter of 1989, the difference in
the estimated values with and without the tax
rate changes is about six percentage points. This
suggests that the Act facilitated higher leverage,
which might explain why nonfinancial corpora-
tions' debt grew at only a slightly slower pace
during the six quarters following the stock mar-
ket crash than it did during the three years
preceding the crash.
Moreover, because increases in stock prices
since the second quarter of 1989 (the last date
plotted in the chart) likely have lowered actual
market-value DIE ratios, nonfinancial firms may
have even more latitude to expand debt.
Risk
As indicated earlier, an increase in risk associ-
ated with higher leverage should raise the cost
of issuing debt and offset the tax incentive to
increase leverage further. Thus, it is useful to
examine how risk has been affected by higher
leverage. One commonly used measure of corpo-
rations' riskiness is the standard deviation of
the return on market-value equity. This measure
reflects the effects of leverage as well as non-
leverage factors, such as asset risk and the
general state of the economy.
Chart 2 shows the quarterly average standard
deviation of daily returns on a market portfolio of
firms traded on the major stock exchanges. This
measure indicates that corporate risk was rela-
tively high in the quarters immediately following
the stock market crash. However, by the second
quarter of 1989, this measure of risk had fallen
below the levels observed before the stock mar-
ket crash, despite the rise in leverage shown in
Chart 1. Whatever effect higher leverage had on
corporate risk, it appears to have been swamped
by the effect of the decline in "non-leverage"
risk. One explanation is that the outlook for the
economy improved through the second quarter
of 1989, as the stock-market crash became more
removed in time.
This decline in perceived risk after 1987 also is
reflected in a decline in the risk premium on so-
called investment-grade corporate debt. The solid
line in Chart 3 shows that for BAA-rated bonds,
the risk premium, as measured by the spread
between the rate on BAA-rated bonds and the 10-
year Treasury bond rate, has fallen sharply. As of
early November, this spread was below the level
observed even before the stock market crash.
(The same is true for higher quality debt.) Despite
higher leverage, then, risk premia for investment-
grade debt are lower than before the Crash.
This decline in the relative cost ofcorporate
debt, coupled with the recent appreciation in
stock prices and the underlying tax-related bias
towards debt, should facilitate debt issuance for
many corporations.
At the same time, however, Chart 3 also indicates
that perceived risk has not declined for all firms.
For some firms, in fact, perceived risk has
increased. The dashed line traces the recent
movements in the risk premium on speculative-Since about half of equity income historically is
received in the form of capital gains, a reduction
in the taxation of capital gains is another way to
reduce the bias toward debt. One such proposal,
considered in a House Ways and Means Com-
mittee bill, could have a significant effect on
grade debt, as measured by the spread between
the rate on B-rated corporate bonds and that on
lO-year Treasury bonds. Responding to concerns
over the problems of certain highly-leveraged
firms, rates on speculative grade bonds rose rela-
tive to Treasury rates in 1989. The higher relative
cost of debt for such firms counters other factors
favori ng the use of debt.
Reducing the bias
From the evidence examined here, as well as that
presented in other research, it is clear that u.s.
tax policy has contributed to higher corporate
leverage. It is equally clear that changes in tax
policy aimed at reducing the bias toward debt
could greatly reduce leverage. With this in mind,
Treasury Secretary Brady and others have called
for reconsideration of the double taxation of
corporate dividends.
leverage. The bill calls for a reduction in the
maximum marginal tax rate on capital gains to
19.6 percent for two years, with a maximum rate
of 28 percent thereafter. That bill also would
reduce tax rates by indexing capital gains for
inflation. Inflation indexation reduces the
effective tax rate by taxing the real, rather than
the nominal, return on capital gains.
Frederick T. Furlong
Research Officer
The effect of indexation on the expected effective
tax rate on capital gains, and, thus, on leverage,
depends on a number of factors, including the
expected rate of inflation. The higher inflation is
expected to be, the lower will be the expected
effective capital gains tax rate on the nominal
return. Assuming an expected inflation rate of
5.35 percent (based on the most recent Drexel,
Burnham, Lambert survey of one-year ahead
inflation expectations), expected capital gains of
10 percent over that year, and a statutory capital
gains tax rate of 28 percent, the effective ex-
pected capital gains tax rate would be about 13
percent. Using the statistical model described
earlier, this capital gainstax rate (holding other
tax rates constant) would reduce the predicted
aggregate, market-value DIE ratio by about six
percentage points, fully offsetting the estimated
effects of the 1986 Tax Act.
Significant changes in the tax laws that would
eliminate or reduce taxes on dividends andlor
capital gains, however, are not likely in the near
future. Without such measures, the analysis pre-
sented here indicates that U.S. tax policy will
continue to foster a market environment that is
favorable to high corporate leverage.
Percentage
Points
7.0
6.0
5.0
4.0
• BAA-rated ond 3.0 l-t ~\ J~ss 10-year
,••" \",T-bond 2.0 ,....
"v
1.0
84 85 86 87 88 89
Chart 3:
Risk Premia on Corporate Bonds
(monthly)
80 81 82 83
• Source: Salomon Brothers.
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board'of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.
JResearch Department
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

Corporate debt

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Corporate debt

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