Arbeitspapier
Optimal Debt Bias in Corporate Income Taxation
I present a rationale for a government to discriminate between debt and equity financing when taxing corporate income. For risk-averse entrepreneurs, equity generates more surplus than debt, because it provides financing and insurance. A government seeking to extract surplus from entrepreneurs would naturally tax equity-generated income more than debt-generated income. I also establish a less obvious reason why the government might want to extract surplus from entrepreneurs. It is well understood that when the quality of projects is unobservable to investors, risk-averse entrepreneurs with higher-return projects might retain a larger share of equity to signal their type (Leland and Pyle (1977)). I show that in such an adverse selection set-ting, while competitive investors are constrained to offer actuarially fair terms, the government can use taxes to discriminate between types. This degree of freedom allows manipulation of the relevant incentive constraints so that a lower level of debt suffices for separation, and an increase in overall efficiency can be obtained. Since entrepreneurs separate along their debt-to-equity ratios, the optimal non-linear tax schedule to achieve the desired discrimination is isomorphic to one that taxes debt-generated income at a lower rate than equity-generated income.
- Language
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Englisch
- Bibliographic citation
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Series: CESifo Working Paper ; No. 5561
- Classification
-
Wirtschaft
General Financial Markets: Government Policy and Regulation
Portfolio Choice; Investment Decisions
Business Taxes and Subsidies including sales and value-added (VAT)
Asymmetric and Private Information; Mechanism Design
- Subject
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corporate taxation
debt bias
investment decision under asymmetric information
- Event
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Geistige Schöpfung
- (who)
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Simon, Jenny
- Event
-
Veröffentlichung
- (who)
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Center for Economic Studies and ifo Institute (CESifo)
- (where)
-
Munich
- (when)
-
2015
- Handle
- Last update
-
10.03.2025, 11:42 AM CET
Data provider
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Object type
- Arbeitspapier
Associated
- Simon, Jenny
- Center for Economic Studies and ifo Institute (CESifo)
Time of origin
- 2015
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