In this paper we question the idea that the deduction of debt interest is always an effective policy instrument to spur firm investment. We analyze the investment decision in presence of a borrowing constraint on the amount of the debt that the firm can raise. We show that if the debt interest rate is decreasing in the firm capital accumulation and it is available another financial resource more expensive than debt (at least for levels of debt lower than the upper bound), then the deduction of the debt interest from taxes on capital income may reduce firm investment. This theoretical result should be considered when financial intermediaries are not willing to finance beyond a certain threshold but firms have access to other sources of finance.Corporate taxation; Financing constraints; Investment

Addessi, William

Saltari, Enrico

English

Research Papers in Economics

The e⁄ect of debt tax bene￿ts
on ￿rm investment decisions
William Addessi￿ Enrico Saltariy
This Version: December 17, 2011
Abstract
In this paper we question the idea that the deduction of debt interest is always an e⁄ective
policy instrument to spur ￿rm investment. We analyze the investment decision in presence of
a borrowing constraint on the amount of the debt that the ￿rm can raise. We show that if
the debt interest rate is decreasing in the ￿rm capital accumulation and it is available another
￿nancial resource more expensive than debt (at least for levels of debt lower than the upper
bound), then the deduction of the debt interest from taxes on capital income may reduce ￿rm
investment. This theoretical result should be considered when ￿nancial intermediaries are not
willing to ￿nance beyond a certain threshold but ￿rms have access to other sources of ￿nance.
JEL Classi￿cation: D21, G31, H32
Keywords: Corporate taxation, Financing constraints, Investment
￿University of Rome "La Sapienza", Department of Economics and Law. Email: w.addessi@gmail.com.
yCorresponding author. University of Rome "La Sapienza", Department of Economics and Law, via del Castro
Laurenziano 9, 00161 Rome (Italy), fax +39 06 4462040; tel. +39 06 49766213. Email: Enrico.Saltari@uniroma1.it.1 Introduction
This paper investigates whether the tax bene￿ts of debt may have negative e⁄ects on the ￿rm
investment. It is reasonable to expect that interest deduction always spurs investment because
it reduces the cost of the debt. Perhaps surprisingly, we show that under credit rationing and
endogenous debt interest rate such expectations may be disappointed.
We build on the standard neoclassical model of investment by introducing both ￿nancial con-
straints and distortionary taxation. We analyze the investment decision in the presence of a capital
income tax, a tax bene￿t on the debt interest payments and an upper bound on the debt.
We show that if the debt constraint is binding and the ￿rm has access to other sources of ￿nance
more expensive than debt, tax bene￿ts of debt discourage investment. The intuition of this result is
as follows. When the debt interest rate is inversely related to capital stock, there is an incentive to
invest because each additional unit of capital reduces the debt burden, i.e. the interest payments.
If tax bene￿ts of debt are introduced, capital accumulation a⁄ects the debt burden in two
opposite ways: i) tax bene￿ts imply that only a fraction of the interest rate is actually paid by
the ￿rm and, then, the reduction caused by capital accumulation of the unit cost of debt (the debt
interest rate) is lower; ii) tax bene￿ts stimulate debt accumulation and, by this way, the reduction
of the interest rate induced by capital accumulation applies to a larger amount of debt. The ￿rst
e⁄ect means that the introduction of tax bene￿ts reduces the incentive to invest, while the second
raises it. Under general conditions and no credit rationing, the second e⁄ect is dominant and tax
bene￿ts spur ￿rm investment. On the contrary, if there is credit rationing only the ￿rst e⁄ect is
present and, consequently, the incentive to invest decreases as tax bene￿t rate increases.
The paper is organized as follows: Section 2 illustrates the theoretical model; Section 3 deter-
mines the optimal solutions of the model distinguishing between the case with no binding constraint
on debt and the case in which the optimal level of debt is higher than the upper bound; Section 4
concludes and discusses some policy implications.
12 The model
This section presents a baseline model describing the ￿nancial and investment choices of a risk neu-
tral ￿rm.1 Our framework mainly refers to two ￿elds of the economic literature on ￿rm investment.
First, we analyze the role of ￿nancial constraints on the investment choice thus following the strand
of research that relax the assumption of perfect capital markets.2 Moreover, we consider the role
of distortionary taxation on both real investment and corporate ￿nancing decisions.3
The characterizing elements of the model are: i) endogeneity of the debt interest rate; ii) an
upper-bound constraint; and iii) taxation on capital revenue that is instrumental to the introduction
of deduction of interest payments. Let us discuss the assumptions that characterize our theoretical
framework.
To our aims it is su¢ cient to hypothesize that the debt in period t, b, is a way to raise resources
whose cost is, at least below a certain level of debt, cheaper than internal funds. In fact, even if
debt requires the payment of a risk premium (see below), the distortionary tax scheme makes debt
the dominating source of ￿nancing for low levels of debt (see Shahnazarian, 2009).4 Debt interest
rate, r = r(b;k), is increasing in debt (@r
@b > 0) and decreasing in capital (@r
@k < 0). This relationship
takes into account the risk of the lender in the price of debt.5 We adopt a simple functional form
(see Bond and S￿derbom, 2011) that allows us to derive a closed form solution. Speci￿cally:
r = ￿ + ￿
b
k
, (1)
where ￿ is the cost of internal resources and the second term represents the risk premium with
￿ > 0. Moreover, we assume that the debt has an upper bound, B.6
1For an analysis of investment decisions of a risk-averse ￿rm, see Saltari and Ticchi (2005, 2007).
2We limit ourselves to mention the seminal contribution Fazzari et al. (1988) and cite Hubbard (1998) as a
reference survey.
3See Hasset and Hubbard (1996), Graham (2003) for a survey on the role of taxes in the corporate ￿nance strategy
and Gordon and Lee (2001) for empirical evidence.
4In a previous version of this paper we used a standard hierarchy model where the cost of debt was intermediate
between a cheaper source of ￿nancing (i.e. internal funds) and a more expensive source of ￿nancing (i.e. new equity
issue). However, the inclusion of equities does not add any interesting elements, since what we need is a source of
￿nancing more expensive than debt.
5For a general treatment of this topic see Bond and Meghir (1994) and Pratap and Rendon (2003).
6As highlighted by Whited (1992), for the upper bound to be e⁄ective, it is important that ￿rm cannot a⁄ect it.
The debt limit could also be assumed increasing in the ￿rm capital stock. However, assuming that the maximum
debt is proportional to ￿rm capital stock (as in Saltari and Travaglini, 2003), would not signi￿cantly a⁄ect the main
result of the paper, since it would only add a constant term to the optimality condition of capital accumulation that
2We consider capital income taxation (we make no distinction between dividend and capital
gains) with ￿k as the tax rate; it also represents the upper bound for the interest deduction rate,
￿b, i.e. we assume that ￿b ranges between zero (no tax bene￿t) and ￿k (full deductibility).
The other elements featuring the model are quite standard. The ￿rm output y is increasing
and concave in capital, y = zk￿ where 0 < ￿ < 1 and z is an i.i.d. stochastic productivity shock.7
For simplicity, we normalize to 1 the expected value of z and suppose that there is no capital
depreciation.8 Finally, the discount factor is equal to the cost of internal resources, ￿.
Under these assumptions it is possible to de￿ne the ￿rm￿ s maximization problem solving the
following maximazion problem:
max
k;b;￿
￿ = (1 ￿ ￿k)E (z)k￿ ￿ br(1 ￿ ￿b) + ￿ (B ￿ b) ￿ ￿(k ￿ b)g
where k = c + b and ￿ is the Lagrangian multiplier associated with the debt constraint and E is
the expectation operator.9
We solve this maximization problem by ￿rst de￿ning the weighted average cost of capital
(WACC) as follows:
rk = ￿
￿
1 ￿
b
k
￿
+ (1 ￿ ￿b)r
b
k
(2)
= ￿ ￿ ￿￿b
b
k
+ ￿ (1 ￿ ￿b)
￿
b
k
￿2
(3)
so that the maximization problem can simply be rewritten as
max
k;b;￿
￿ = (1 ￿ ￿k)E (z)k￿ ￿ krk + ￿ (B ￿ b) (4)
does not interact with the rate of the tax bene￿t. Assuming a non linear relationship would prevent a closed form
solution.
7In this case capital returns and value added overlap, as in Pratap and Rendon (2003). Alternatively, we could
have assumed constant returns to scale and convex adjustment costs in the investment function. This option would
have modi￿ed the analytical results but not the qualitative role of the tax rate and the interest deduction rate.
8The characterization of z allows us to introduce a source of uncertainty that explains the risk premium associated
with debt. At the same time, since the expected value of z enters linearly in the ￿rst order conditions, we will write
it using E[z] = 1 and, consequently, the expectation operator will not appear.
9We wrote the ￿rm￿ s maximization problem assuming that ￿rm￿ s tax base is positive (y ￿ rb > 0). Furthermore,
we con￿ne our analysis to the case in which the debt is positive. The introduction of other constraints will not modify
qualitatively our conclusions since they are not binding in the case we are interested in.
3The ￿rst order condition for capital implies the equality between the expected marginal pro-
ductivity of capital and the marginal cost of ￿nancing,
@(rkk)
@k :
(1 ￿ ￿k)￿k￿￿1 = ￿ ￿ ￿ (1 ￿ ￿b)
￿
b
k
￿2
(5)
Equation (5) describes the optimal capital accumulation. On the left there is the net (of taxes)
expected return on capital.10 The ￿rm invests until this return is equal to the cost of capital. In
turn, this is given by the cost of internal resources plus the marginal e⁄ect of capital accumulation
on the cost of debt ￿nancing. Indeed, the second addend on the right shows that when the debt
interest rate is decreasing in capital, the ￿rm has the incentive to invest in order to reduce the risk
premium and thus the debt burden. It is important to observe that, coeteris paribus, this reduction
is increasing in the amount of debt but decreasing in the debt deduction rate.
Since capital markets are imperfect, we can determine the optimal capital structure, say b
k; by
minimizing the WACC with respect to b
k:
drk
d b
k
= ￿￿￿b + (1 ￿ ￿b)2￿
b
k
= 0
that is ￿
b
k
￿￿
=
￿
2￿
￿b
1 ￿ ￿b
(6)
By using this solution, we ￿rst determine the optimal capital stock when there is no constraint
and then, using again Equation (6), the level of debt, b:
3 Results and discussion
Substituting equation (6) in the ￿rst-order condition for capital gives:
(1 ￿ ￿k)￿k
￿￿1
nb = ￿ ￿ (1 ￿ ￿b)
￿
￿
2￿
￿b
1 ￿ ￿b
￿2
or
10Had we chosen a framework with constant returns to scale and convex adjustment costs, the tax rate of capital
returns would have appeared in an additive, not multiplicative, way but the direction of the e⁄ect would have been
the same.
4knb =
0
B
B
@
￿ (1 ￿ ￿k)
￿
￿
1 ￿ ￿
￿2
b
4￿ (1 ￿ ￿b)
￿
1
C
C
A
1
1￿￿
(7)
where the subscript nb indicates that the debt constraint is not binding. From equation (7) it is
straightforward to verify that an increase in ￿b boosts capital accumulation. The optimal amount
of debt is simply:
bnb = knb
￿
2￿
￿b
1 ￿ ￿b
(8)
Now, suppose the constraint is binding. The optimal solution in this case is determined by substi-
tuting the debt threshold B < bnb in the ￿rst order condition for capital, equation (5). It reads:
￿ (1 ￿ ￿k)k
￿￿1
bind = ￿ ￿ ￿ (1 ￿ ￿b)
￿
B
kbind
￿2
(9)
where the subscript bind indicates that the constraint on debt is binding. From equation (9) one
can show that when the optimal debt is higher than the threshold value of debt, an increase in the
deduction rate reduces investment.11;12
Thus, an increase in tax bene￿t has opposite e⁄ects according to whether the debt constraint
binds or not. To see what is at work here, it is useful to look at the e⁄ect of capital accumulation
on the debt burden (interest payments). Of course, this is just the product of two elements ￿the
unit cost of debt net of tax bene￿t, i.e. (1 ￿ ￿b)r, and the amount of debt, i.e. bt. We assumed
that capital accumulation reduces the risk premium and therefore the interest rate. This creates
an incentive to invest. What happens to this incentive when the deduction rate increases? First,
it decreases the marginal e⁄ect of capital accumulation on the interest rate, thus reducing the
incentive to invest, but, second, it increases the optimal amount of debt13 ￿thus enlarging the base
11The derivative is:
@kbind
@￿b
=
￿
￿
Bt
bindk
￿2
￿ (￿ ￿ 1)k
￿￿2
bind ￿ 2￿ (1 ￿ ￿b)
B2
t
k3
bind
< 0
12It is worth noticing that one can obtain the same results reversing the procedure followed thus far. Instead of
￿rst maximizing the pro￿t and then determining the optimal capital structure, one can ￿rst minimize the cost of
￿nancing ￿and thus the optimal capital structure ￿and then maximize the pro￿t.
13This is simple to verify. We have seen above that the capital stock k is increasing in ￿b when the debt constraint
is not binding. On the other hand, the ￿rst-order condition for debt, eq.(8), says that the optimal debt increases
with ￿b and k. It follows that the optimal debt is also increasing in ￿b:
5to which the interest rate reduction applies so stimulating investment. We know from equation (7)
that overall this latter e⁄ect is stronger than the former since capital accumulation increases with
￿b. In other words, the higher ￿b the higher the incentive to invest.
On the other hand, when the constraint on debt is binding, only the direct e⁄ect on the unit
cost of debt matters because the debt cannot be increased. Thus, the marginal e⁄ect of capital
accumulation on the debt burden is weakened as tax bene￿t increases. This explains the negative
relationship between the ￿rm investment and the deduction rate that emerges from equation (9).
To sum up, our analysis of the relationship between ￿rm investment and tax bene￿ts shows
that its sign depends on whether the constraint on the maximum amount of debt binds or not. Or,
to put it another way, the e⁄ectiveness of tax bene￿ts in stimulating investment is linked to the
possibility to raise debt. We thus have two possible regimes.
Regime 1: nbb < B (debt constraint is not binding). Increases in tax bene￿ts spur investment
because they decrease the marginal cost of capital.
Regime 2: nbb ￿ B (debt constraint is binding). Increases in tax bene￿ts sap investment because
they increase the marginal cost of capital.
4 Conclusions
Our analysis shows that when the interest rate is decreasing in the capital accumulation and
￿rms are rationed in the debt market, increases in tax bene￿ts reduce investment if ￿rms use an
alternative source of ￿nancing to overcome such binding constraint. This theoretical result suggests
caution in using tax bene￿ts as a policy instrument when ￿rms are rationed. In fact, if the credit
crunch is circumscribed to the debt market while ￿rms have access to other ￿nancial resources,
then tax bene￿ts may reduce investment.
Moreover, it also suggests that the form of the binding constraint on the level of debt we used
is not as decisive as it may seem. In fact, as we have also alluded to, if the constraint is not binding
the optimal level of capital can also be obtained by ￿rst minimizing the cost of capital with respect
to the debt-capital and then equating it to its marginal productivity. Therefore, the truly relevant
variable to the optimization process is the ￿rm ￿nancial structure, i.e. its debt to capital ratio. It
follows that the binding constraint could also be reformulated by taking into account the ￿rm size,
6as summarized by the level of its capital stock. We leave this task to future research.
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8

The effect of debt tax benefits on firm investment decisions

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