Corporate Taxes, Leverage, and Business Cycles

This paper evaluates quantitatively the implications of the preferential tax treatment of debt in the United States corporate income tax code. Specifically, we examine the economic con- sequences of allowing firms to deduct interest expenses from their tax liabilities on financial variables such as leverage, default decisions and credit spreads. We conduct a series of policy experiments in which the tax deductibility of the corporate interest expense is eliminated. As expected, this results in a substantial decrease in the equilibrium level of leverage. However, contrary to conventional wisdom, we find that eliminating interest deductibility results in an increase in the default frequency and average credit spreads in the economy. The intuition for this lies in the fact that this policy change makes external financing more costly, resulting in riskier firms and higher credit spreads.