## _sdn1111

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### Executive summary — Overview
- Most tax systems contain a “debt bias”: interest is deductible for corporate income tax (CIT) while equity returns (dividends and capital gains) typically are not.
- Debt bias is increasingly hard to justify on legal, administrative, or economic grounds and its welfare costs may be larger than previously thought.
- Recent developments raising concern:
  - Companies increasingly respond to debt incentives, raising public-welfare cost.
  - The economic crisis highlighted harmful effects of excessive leverage in the banking sector and systemic effects of bank failure.
  - Hybrid financial instruments and internal restructuring enable tax avoidance that erodes public revenues.

### Evidence and economic effects
- Empirical findings:
  - Debt bias has produced inefficiently high debt-to-equity ratios in corporations.
  - It discriminates against innovative growth firms and can impede stronger economic growth.
  - It enables tax avoidance via hybrid instruments and intra-firm debt shifting.
- Cost-of-capital calculations for 2007 (post-tax return assumed 5 percent; inflation 2 percent) — selected figures:
  - USA (PIT-exempt investor): Retained earnings 9.2; New equity 9.2; Debt 4.8.
  - USA (PIT-taxed investor at top rate): Retained earnings 5.8; New equity 6.5; Debt 4.9.
  - Japan (PIT-exempt investor): Retained earnings 10.4; New equity 10.4; Debt 5.6.
  - Japan (PIT-taxed investor at top rate): Retained earnings 9.5; New equity 15.4; Debt 5.6.
  - EU-27 average (PIT-exempt investor): Retained earnings 6.8 <5.0 ; 9.0>; New equity 6.9 <5.6 ; 9.0>; Debt 4.6 <3.9 ; 5.3>.
  - EU-27 average (PIT-taxed investor at top rate): Retained earnings 5.6 <3.5 ; 6.9>; New equity 6.4 <3.0 ; 9.3>; Debt 4.7 <4.0 ; 5.6>.
- Three messages from cost-of-capital calculations:
  - In all three regions, cost of equity-financed investment is higher than cost of debt-financed investment (for both PIT-exempt and PIT-taxed investors).
  - Bias toward debt is generally smaller for PIT-taxed investors than for PIT-exempt investors, but significant for both.
  - In the EU and the US, debt is subsidized at the margin—the pre-tax return necessary for debt-financed investment can be lower than the assumed post-tax return of 5 percent—partly due to accelerated depreciation and nominal interest deductibility.
- International implications and trends:
  - Interest deductibility combined with international differences in statutory CIT rates creates incentives for debt shifting within multinationals.
  - Average CIT rates cited: Europe average 23.2 percent; U.S. approaches 40 percent. Within Europe, rates vary between 9 and 35 percent.
  - Between 1998 and 2007 in the EU-25: cost of capital on retained earnings fell from 7.7 to 6.9 percent; cost on debt rose from 4.3 to 4.6 percent.
  - Thin-capitalization rules expanded among OECD countries: share applying such rules grew from less than 50 to more than 75 percent between 1996 and 2004.
  - Standard deviation of CIT rates among 64 countries between 2001 and 2010 increased from 6.8 to 7.7 percent, increasing incentives for multinationals to shift debt into high-tax

### Rationale — Legal and administrative considerations
- Legal distinctions commonly used in tax law:
  - Debt: legal right to fixed return; prior claim on assets in insolvency; no control rights.
  - Equity: residual, variable returns; residual claims; control rights.
- Hybrid instruments (preference shares, convertible debt, junk bonds, subordinated debt, warrants, indexed securities) blur the debt–equity distinction and complicate deductibility rules.
- Intracompany debt challenges:
  - When parent fully owns subsidiary, transfer pricing of interest is hard because prior and residual claims are held by the same entity; creates profit-shifting opportunities.
- Administrative arguments for interest deductibility are questioned:
  - Both debt and equity returns can be non-obvious (bond value changes, retained earnings), undermining claims of administrative convenience for favoring debt.
  - High administrative costs of current CIT systems support a move toward greater neutrality rather than continued discrimination.

### Rationale — Economic considerations
- Complete-markets benchmark:
  - Under Modigliani and Miller (1958) with complete markets, firm value independent of financial structure; tax-induced changes would have no welfare effect.
- Real-world imperfections:
  - Informational and agency frictions mean market-chosen capital structures may be socially inefficient; taxes can mitigate or exacerbate these distortions.
  - Corporate finance theories do not clearly support a general presumption that debt levels are too high or too low for non-financial firms.
- Signaling example:
  - Gordon (2010): asymmetric information could justify a debt tax advantage if debt issuance signals bad health and healthy firms otherwise borrow too little—empirical evidence is inconclusive and may point the other way.

### Welfare costs
- Direct deadweight-loss estimates:
  - Weichenrieder and Klautke (2008) estimates: marginal impact of tax on debt-asset ratio between 0.14 and 0.46; marginal deadweight loss between 0.05 percent and 0.15 percent of the capital stock — equal to between 0.08 and 0.23 percent of GDP for a capital stock of 1.5 times GDP.
- Amplifying factors that increase welfare costs beyond direct deadweight estimates:
  - Financial-sector externalities: banks face moral hazard from deposit insurance and guarantees, choose excessively high debt; bank failures create systemic externalities.
  - Business cycle amplification: higher leverage raises probability and depth of financial crises (Bianchi, 2010); welfare cost of increased volatility is difficult to quantify but potentially large.
  - Tax arbitrage: hybrid instruments and multinational debt shifting create administrative/compliance costs and erode CIT base; high-tax countries lose revenue while low-tax countries gain taxable inflows, possibly intensifying tax competition.
- Net assessment: welfare costs of debt bias are probably substantial and likely exceed traditional deadweight loss estimates, especially for financial institutions where externalities may justify taxing debt.

### Evidence on debt bias (meta-analysis and dynamics)
- Meta-analysis based on 267 estimates from 19 studies:
  - Consensus estimate for impact of CIT rate on debt-asset ratio between 0.17 (narrow) and 0.28 (broad).
  - A coefficient of 0.28 implies a 10 percentage-point lower CIT rate (e.g., 40 to 30 percent) reduces debt-asset ratio by 2.8 percent (example: from 50 to 47.2 percent).
  - A country with a CIT rate of 36 percent that fully eliminated the corporate tax advantage of debt would see average corporate debt-asset ratio fall by 10 percent (example: from 50 to 40 percent).
- Time variation:
  - Studies with average sample year 1992 yield typical tax impact 0.19.
  - Studies using 2011 data produce expected tax impact 0.30 (approximately 50 percent larger).
  - Despite increased use of restrictions on interest deductibility, debt bias appears more important over time.
- Sectoral and intracompany findings:
  - Most empirical studies focus on non-financial firms; lack of studies isolated to financial firms.
  - Evidence suggests bank capital structures may follow similar determinants as non-financial firms.
  - Elasticities of intracompany debt by multinationals are reported larger than third-party debt (though meta-regressions do not sustain this difference); intracompany distortions reflect tax arbitrage rather than aggregate leverage decisions.

### Box 1 — Models of optimal capital structure and implications
- Four corporate finance models under informational imperfections:
  - Bankruptcy costs: trade-off between tax shield and higher bankruptcy risk.
  - Agency costs (managers vs shareholders): debt as constraint on managerial waste.
  - Agency costs (shareholders vs bondholders): shareholder incentives to shift risk to bondholders.
  - Signaling/pecking order (Ross; Myers and Majluf): internal finance, then debt, then external equity.
- Credit constraints and firm heterogeneity:
  - Information asymmetries can produce credit rationing and underinvestment (Stiglitz and Weiss, 1981).
  - De Meza and Webb (1987) show information asymmetries can also lead to excessive debt; debt-favoring tax treatment can exacerbate distortions.
  - Credit-constrained firms are often small and innovative; general interest deduction mostly benefits firms already with debt access, risking excessive investment by mature firms and hampering startups.
- International mobility:
  - Debt may be more mobile than equity in theory, but empirical evidence (Fidora et al., 2006) shows home bias in debt and equity portfolios is equally important in integrated areas, questioning mobility-based justification for debt preference.

### Policy responses — two broad approaches
- Two comprehensive reform directions to achieve neutrality:
  - Disallow interest deductibility (Comprehensive Business Income Tax, CBIT).
  - Introduce an Allowance for Corporate Equity (ACE).
- Both eliminate debt–equity discrimination but differ in broader economic properties and practical implications.

A. Restricting interest deductibility (CBIT, thin-capitalization, caps)
- Thin-capitalization rules:
  - Evidence they reduce intracompany debt ratios but may reduce investment; ad-hoc and avoidable via hybrids and definitional differences.
- Interest deduction caps and inflation correction:
  - Options include capping deductible interest, allowing deduction only for real interest, indexing depreciation, and correcting interest receipts for inflation; trade-off between reduced bias and increased complexity.
- Comprehensive Business Income Tax (CBIT):
  - Denies interest deductibility; treats debt as current CIT treats equity.
  - Effects and concerns:
    - Eliminates corporate finance distortions but raises cost of capital on debt-financed investments, reducing investment.
    - Broadens CIT base, allowing lower statutory CIT rates; interacts with international profit shifting (de Mooij and Devereux, 2011).
    - Risks for banks: under CBIT, banks disallowed deduction for interest expenses but not taxed on interest received from CBIT firms, potentially exempting traditional banking and shifting tax burden to non-financial firms.
    - Unilateral CBIT can distort international banking/lending markets and faces practical/transitional challenges (pre-existing debt, short-run amplification of financial distress).
- Partial CBIT on intracompany debt could mitigate multinational debt shifting but requires international coordination; unilateral measures can exacerbate cross-border issues.

B. Allowance for Corporate Equity (ACE) and related approaches
- ACE fundamentals:
  - Deduction for notional return on equity (e.g., set equal to government bond rate).
  - Neutralizes debt-equity choice and marginal investment decisions; taxes economic rents only.
  - Offsets distortions from tax vs economic depreciation because present value of depreciation allowance plus ACE is independent of tax depreciation rate.
- ACC (Allowance for Corporate Capital):
  - Replaces interest deduction with deduction for notional risk-free return on all capital (debt and equity), achieving full neutrality and avoiding intracompany transfer pricing issues.
- International and historical experience:
  - Early experiments: Croatia, Austria, Italy (around millennium change) later terminated as part of CIT-rate reductions.
  - Contemporary adopters/variants: Brazil, Latvia, Belgium.
    - Belgium: notional deduction at 10-year government bond rate (between 3 and 4 percent in recent years); 2008 estimated allowances ≈ 6 billion euro and reduced corporate tax yield by slightly more than 10 percent.
    - Brazil: variant on distributed profit only (introduced 1996); primarily affected dividend payout ratios with small effects on investment and financial structure.
    - Latvia: in 2010 introduced notional deduction on retained earnings; rate equals annual weighted average interest on loans to non-financial businesses.
- Fiscal cost and options to reduce short-run impact:
  - Direct estimated revenue cost: approximately 15 percent of CIT revenue, or 0.5 percent of GDP on average (appendix estimates for 15 developed countries).
  - Narrowing of CIT base estimated between 7 percent (Norway) and almost 20 percent (Australia); direct fiscal cost between 0.25 and 1.0 percent of GDP.
  - Options to reduce short-run fiscal cost:
    - Apply ACE only to new investment.
    - Impose special taxation on debt in financial sector to offset revenue loss.
    - Integrate ACE in an income tax framework (BEIT) or finance with higher VAT.
- Simulation evidence (ACE financed by higher VAT; selected results):
  - de Mooij–Devereux (EU): Debt-asset ratio (absolute change) −4.7; Investment 5.9 percent; Employment 0.4 percent; GDP 1.9 percent.
  - Keuschnigg–Dietz (Switzerland): Debt-asset ratio −3.8; Investment 7.8 percent; Employment 0.4 percent; GDP 2.6 percent.
  - Radulescu–Stimmelmayr (Germany): Investment 20.5 percent; Employment 1.7 percent; GDP 9.1 percent.
  - De Mooij and Devereux (2011): approximately three-quarters of the initial fiscal cost of ACE can be recovered in the long run via behavioral responses.
- Incidence:
  - Empirical evidence (Hassett and Mathur, 2006; Arulampalam and others, 2010) suggests workers bear a large share of CIT incidence; ACE likely benefits employees through higher wages.

### Empirical appendix — selected ACE revenue-impact estimates (method and figures)
- Method summary:
  - Worldscope data for 2005–07; ACE base = book value of equity minus unconsolidated subsidiaries; ACE allowance = equity base × 10-year government bond yield (average 2005–07); loss-making firms assumed ACE = one-half value; aggregates converted to percent of GDP using CIT-to-GDP ratio.
- Table 3 selected country estimates (Sample, Average ACE Rate, Company Tax Base reduction, Revenue effect in percent GDP):
  - UK: 4703, 4.6, − 17.4, − 0.56
  - France: 1502, 3.9, − 15.1, − 0.48
  - Canada: 2695, 4.3, − 19.3, − 0.48
  - Australia: 4018, 5.6, − 20.5, − 0.95
  - Belgium: 293, 3.9, − 16.7, − 0.60
  - Netherlands: 360, 3.8, − 9.8, − 0.34
  - Norway: 397, 4.0, − 7.0, − 0.28
  - Sweden: 827, 3.8, − 12.8, − 0.51
  - Denmark: 389, 3.8, − 12.9, − 0.52
  - Finland: 305, 3.8, − 13.5, − 0.53
  - Italy: 733, 4.0, − 12.6, − 0.40
  - Spain: 362, 3.8, − 10.6, − 0.51
  - Germany: 1729, 3.8, − 16.1, − 0.40
  - U.S.: 11833, 4.6, − 17.5, − 0.43
  - Japan: 7004, 1.6, − 9.4, − 0.38
  - Average: (no sample), 4.0, − 14.1, − 0.49
- Caveats noted:
  - True ACE cost may differ due to differences between equity in tax vs commercial accounts and sample representativeness (example: true Belgian cost ≈ 10 percent of CIT revenue vs sample estimate 16 percent).
  - ACE may apply to corporate and non-corporate firms; adjustments made for Germany.

### Policy conclusions and recommendations
- No compelling legal, administrative, or economic reason to systematically favor debt over equity; debt bias exists and warrants policy attention given likely substantial welfare costs amplified by financial-sector externalities, business-cycle effects, and tax arbitrage.
- Reform pathways:
  - Disallowing interest deductibility (CBIT) eliminates debt bias but has drawbacks: potential bank under-taxation, international distortions, and transitional issues.
  - Partial denial focused on intracompany interest could mitigate multinational debt shifting but requires international coordination.
  - Most promising: introduction of an ACE, with design options to limit short-run fiscal cost (apply only to new investment, offset with banking-sector debt taxes, combine with BEIT or VAT financing).
- Complementary measures:
  - Penalize debt financing in sectors with large externalities (e.g., financial sector) via higher taxes on debt to correct systemic-risk externalities.
- Budgetary and political attractiveness:
  - An ACE combined with sectoral debt penalties shifts tax burden from desirable behavior (new investment) to harmful behavior (excessive debt), helping contain fiscal cost.

*Source: Executive Summary and selected sections of the IMF Staff Discussion Note contained in the supplied PDF content (_sdn1111).*

### Executive Summary ......................................................................................................

### Executive Summary

### Overview
- Most tax systems today contain a “debt bias,” offering a tax advantage for corporations to finance their investments by debt.
- Debt bias arises because interest payments are deductible for corporate income tax (CIT) purposes while equity returns (dividends and capital gains) are typically not deductible.
- The note argues that debt bias is increasingly hard to justify on legal, administrative, or economic grounds and that its welfare costs may be larger than previously thought.
- Recent developments raising concern:
  - Companies increasingly respond to debt incentives, raising the associated public-welfare cost.
  - The economic crisis highlighted harmful effects of excessive leverage in the banking sector and the systemic effects of bank failure.
  - Hybrid financial instruments and internal restructuring enable tax avoidance that erodes public revenues.

### Evidence and Economic Effects
- Empirical evidence indicates:
  - Debt bias has produced inefficiently high debt-to-equity ratios in corporations.
  - It discriminates against innovative growth firms, impeding stronger economic growth.
  - It enables tax avoidance via hybrid instruments and intra-firm debt shifting.
- Table 1 (cost of capital calculations for 2007) key figures (post-tax return assumed 5 percent; inflation 2 percent):
  - USA (PIT-exempt investor): Retained earnings 9.2; New equity 9.2; Debt 4.8.
  - USA (PIT-taxed investor at top rate): Retained earnings 5.8; New equity 6.5; Debt 4.9.
  - Japan (PIT-exempt investor): Retained earnings 10.4; New equity 10.4; Debt 5.6.
  - Japan (PIT-taxed investor at top rate): Retained earnings 9.5; New equity 15.4; Debt 5.6.
  - EU-27 average (PIT-exempt investor): Retained earnings 6.8 <5.0 ; 9.0>; New equity 6.9 <5.6 ; 9.0>; Debt 4.6 <3.9 ; 5.3>.
  - EU-27 average (PIT-taxed investor at top rate): Retained earnings 5.6 <3.5 ; 6.9>; New equity 6.4 <3.0 ; 9.3>; Debt 4.7 <4.0 ; 5.6>.
- Three important messages from the cost-of-capital calculations:
  - In all three regions, the cost of equity-financed investment is higher than that of debt-financed investment (both for PIT-exempt and PIT-taxed investors).
  - The bias toward debt is generally smaller for PIT-taxed investors than for PIT-exempt investors, but it is significant for both.
  - In the EU and the US, debt is subsidized at the margin—the pre-tax return necessary for debt-financed investment can be lower than the assumed post-tax return of 5 percent—partly due to accelerated depreciation and nominal (rather than real) interest deductibility.
- International implications:
  - Interest deductibility combined with international differences in statutory CIT rates creates incentives for debt shifting within multinationals.
  - Average CIT rates cited: Europe average 23.2 percent; U.S. approaches 40 percent. Within Europe, rates vary between 9 and 35 percent.
  - Declining CIT rates and restrictions on interest deductibility may have reduced debt bias somewhat. Example: in the EU-25 between 1998 and 2007, cost of capital on retained earnings fell from 7.7 to 6.9 percent, while that on debt rose from 4.3 to 4.6 percent.
  - Thin-capitalization rules expanded among OECD countries: share applying such rules grew from less than 50 to more than 75 percent between 1996 and 2004.
  - Regional dispersion: the standard deviation of CIT rates among 64 countries between 2001 and 2010 increased from 6.8 to

### Rationale and Legal/Economic Considerations
- The note examines both legal and economic rationales for debt bias and finds them unconvincing as a justification for preferential tax treatment of debt.
- Legal basis: no compelling legal grounds to favor debt in taxation are identified in the executive summary.
- Economic rationale: standard economic arguments do not provide compelling support for debt preference; moreover, debt bias can exacerbate financial-sector fragility and distort firms’ capital structures.
- Institutional changes noted:
  - As of January 2011, Japan cut its CIT rate from 40 to 35 percent (affecting comparative incentives).
  - Imputation systems and personal income tax treatments can alter the magnitude of debt bias in specific countries.

### Welfare Costs
- The welfare costs of debt bias include:
  - Distortions to corporate capital structure (inefficiently high leverage).
  - Reduced investment and slower economic growth, especially for innovative firms.
  - Fiscal erosion through avoidance and profit shifting.
  - Increased systemic risk from highly leveraged financial institutions.
- The crisis and evolving behavior of firms suggest these welfare costs have increased over time.

### Policy Responses
- Two broad policy approaches to mitigate debt bias:
  A. Restricting Interest Deductibility
    - Examples include thin-capitalization rules and other limits on interest deductibility.
    - These measures have been adopted by many countries but do not eliminate debt bias entirely.
    - They introduce complexities and new opportunities for tax avoidance.
    - Abolishing interest deductibility would remove the bias but would introduce new investment distortions and be very difficult to implement; no country has moved to fully abolish the deduction.
  B. Allowance for Corporate Equity (ACE)
    - Introduce a deduction for the normal return on equity (for example, equal to the rate of government bonds).
    - Advantages:
      - Eliminates debt bias.
      - Expected to increase investment, raise wages, and boost economic growth.
      - Several countries have introduced variants successfully (Belgium and Latvia cited as recent movers).
    - Main obstacle:
      - Budgetary cost, estimated at around 0.5 percent of GDP for an average developed country.
    - Design and transition considerations:
      - Short-run cost could be reduced by granting the allowance only to new investment.
      - Long-term budgetary cost is expected to decline as favorable economic effects broaden the tax base.
      - Appendix contains estimates of direct revenue impact across countries; Table 3 and related materials elaborate on estimated direct revenue effects.

### Toward More Neutrality
- Achieving greater neutrality between debt and equity will require either:
  - Reducing the tax deductibility of interest (with attendant complexity and partial effectiveness), or
  - Introducing an allowance for corporate equity (which more directly eliminates debt bias and yields positive economic effects but entails initial fiscal cost).
- Policy design should consider differences across firm types (non-financial firms, multinationals, financial institutions) and country-specific contexts, especially where foreign or PIT-exempt investors dominate financing.
- Transition options (e.g., applying allowances to new investment only) can mitigate short-run fiscal impacts while moving toward neutrality.

*Source: Executive Summary of the IMF staff note contained in the provided PDF content.*

### 7.7 percent. This has increased incentives for multinationals to shift debt into high-tax

### _sdn1111 - 7.7 percent. This has increased incentives for multinationals to shift debt into high-tax

### Evidence on Debt Bias
- Meta-analysis evidence:
  - A meta-analysis based on 267 estimates from 19 different studies finds a “consensus estimate” regarding the impact of the CIT rate on the debt-asset ratio between 0.17 for narrow and 0.28 for broad measures of financial leverage.
  - A coefficient of 0.28 implies that a 10 percent-point lower CIT rate, e.g., from 40 to 30 percent, reduces the debt-asset ratio by 2.8 percent (example: from 50 to 47.2 percent).
  - A country with a CIT rate of 36 percent that would fully eliminate the corporate tax advantage of debt would see the average corporate debt-asset ratio fall by 10 percent (example: from 50 to 40 percent).
- Time variation in elasticities:
  - Studies with an average sample year of 1992 yield a typical tax impact of 0.19.
  - Studies using data for 2011 would produce an expected tax impact of 0.30, i.e., approximately 50 percent larger.
  - Despite increasing use of restrictions on interest deductibility, these results suggest debt bias has become more important over time.
- Sectoral considerations:
  - Existing empirical studies focus on non-financial firms or make no distinction by sector; there is a lack of studies specifically analyzing financial companies.
  - Banks face regulatory capital requirements that can reduce tax responsiveness but also have ample opportunities to use hybrid financial structures, leaving ambiguous net responsiveness to tax.
  - Evidence by Flannery and Rangan (2008), Berger and others (2008), and Gropp and Heider (2010) suggests bank capital structures are determined by the same factors as non-financial firms; as a presumption, banks may respond similarly to debt bias as non-financial firms.
- Intracompany debt and profit shifting:
  - Econometric studies report that elasticities of intracompany debt by multinationals are larger than those of third-party debt (though this difference is not sustained in between-study variation in meta-regressions).
  - Distortions in intracompany capital structure reflect tax arbitrage rather than aggregate leverage decisions.

### Rationale for Debt Bias
#### A. Legal Basis
- Common legal distinctions between debt and equity used in tax laws:
  - Debt holders have a legal right to receive a return that is fixed in advance, whatever the financial position of the borrower; equity holders receive a return that is variable and based on firm performance.
  - Debt holders have a prior claim to the firm’s assets if it is insolvent; equity suppliers receive residual claims after debt repayment.
  - Debt suppliers have no control rights over the firm; equity suppliers do.
- Complexity from hybrid instruments:
  - Hybrid instruments (preference shares, convertible debt, junk bonds, subordinated debt, warrants, indexed securities) blur the debt–equity distinction and complicate deductibility rules for CIT.
  - Hybrids allow investors to choose taxation at the CIT rate (by investing in equity) or at their individual PIT rate (by investing in debt) (Shaviro, 2009).
  - Divergent national definitions of debt further open opportunities for tax arbitrage (Schon, 2009).
- Intracompany debt challenges:
  - When a parent fully owns a subsidiary, the parent controls the subsidiary and holds residual claims but may still supply capital via intracompany debt for governance motives or to control free cash flow.
  - Determining an appropriate interest rate and risk premium for intracompany debt is difficult because prior and residual claims are held by the same entity; transfer pricing of interest creates profit-shifting opportunities.
- Administrative arguments and neutrality:
  - The traditional rationale that interest deductibility reflects that “interest is a cost of doing business and equity returns reflect business income” is questioned: economically both are returns to capital.
  - Administrative convenience arguments (e.g., easier observation of interest payments vs. equity retention) are flawed because returns on debt can come from bond value changes and equity returns can be cash dividends.
  - High administrative costs associated with current CIT systems provide an argument for greater neutrality between debt and equity rather than discrimination.

#### B. Economic Rationale
- Theory in complete markets:
  - Under complete markets and perfect information (Modigliani and Miller, 1958), a company’s choice between debt and equity is socially efficient and firm value does not depend on financial structure; tax-induced changes would have no welfare effect.
- Market imperfections and second-best considerations:
  - Real-world informational imperfections among managers, shareholders, and creditors mean market-chosen capital structures may be socially inefficient; taxes that change debt–equity ratios can mitigate or exacerbate these distortions.
- Ambiguity in corporate finance theories:
  - Corporate finance theories do not give clear guidance on whether non-financial firms’ debt levels are too high or too low.
  - The blurring of the debt–equity boundary raises doubts about the relevance of theories focused on that traditional distinction, suggesting a shift toward theories of optimal contract design might be more relevant.
  - Firm heterogeneity complicates universal theoretical prescriptions.
- Example: signaling and debt bias
  - Gordon (2010) suggests asymmetric information between investors and managers could justify debt bias: if debt issuance signals bad health, borrowing by healthy firms will be too low, and a tax advantage to debt could encourage efficient borrowing by healthy firms.
  - However, empirical evidence on the signaling effect of debt is inconclusive; if debt issuance signals good health, the tax advantage would have the opposite effect.

*Italic source attribution: IMF Staff Discussion Note — content from the supplied PDF excerpt.*

### Box 1. Optimal Capital Structure in Corporate Finance Models

### Box 1. Optimal Capital Structure in Corporate Finance Models

### Models of optimal capital structure
- Four models describe optimal debt-equity choice under informational imperfections:
  - Bankruptcy costs: higher debt increases bankruptcy risk, creditors demand higher interest (private cost), trade-off with tax shield.
  - Agency costs (managers vs shareholders): free cash flow leads managers to wasteful investment; issuing debt constrains managers (Easterbrook, 1984; Jensen, 1986).
  - Agency costs (shareholders vs bondholders): shareholders can shift bankruptcy risk to bondholders by encouraging excessive debt.
  - Signaling costs: debt issuance can signal firm health (Ross, 1977) or, per Myers and Majluf (1984), external financing can signal bad health and cause adverse selection, producing a pecking order: (1) internal finance, (2) debt, and (3) external equity.
- Empirical evidence on signaling is inconclusive: Smith (1986) finds leverage-increasing transactions generally raise stock prices; Gordon (2010) cites studies with opposite findings.

### Debt bias, credit constraints, and international mobility
- Information asymmetries can cause credit rationing (Stiglitz and Weiss, 1981), leading to underinvestment and too low levels of debt.
- De Meza and Webb (1987): information asymmetry in both debt and equity markets can lead to excessive debt; debt-favoring tax treatment can exacerbate distortions.
- Targeting: credit constraints tend to concentrate among small and innovative growth firms; a general interest deduction mostly benefits firms already with debt access, risking excessive investment by mature firms and hampering startups.
- International mobility: debt may be more mobile than equity due to different information asymmetries (Gordon and Bovenberg, 1996), but empirical evidence (Fidora and others, 2006) shows home bias in debt and equity portfolios in integrated areas like the EU and the U.S. is equally important, casting doubt on mobility-based arguments for preferential debt taxation.
- Conclusion: second-best considerations do not provide compelling justification for systematic tax preference for debt.

### Welfare cost of debt bias
- Deadweight loss framework: private investors consider marginal non-tax cost of debt and sum of non-tax plus tax costs of equity; debt tends to be chosen excessively when tax favors debt.
- Weichenrieder and Klautke (2008) estimates:
  - Marginal impact of tax on debt-asset ratio between 0.14 and 0.46.
  - Marginal deadweight loss of the tax distortion between 0.05 percent and 0.15 percent of the capital stock — equal to between 0.08 and 0.23 percent of GDP for a capital stock of 1.5 times GDP.
  - Interpretation: aggregate welfare cost of debt bias is fairly modest by this calculation.
- Amplifying factors making welfare costs larger:
  - Financial sector externalities: banks face moral hazard (deposit insurance, implicit/explicit guarantees), choose excessively high debt; bank failures create systemic externalities that individual banks do not internalize (Claessens and others, 2010).
  - Business cycle amplification: higher leverage raises probability and depth of financial crises (Bianchi, 2010); welfare cost of increased volatility is hard to quantify but can be substantial, as suggested by recent crisis experience.
  - Tax arbitrage costs: hybrid instruments and multinational debt shifting create administrative and compliance costs and erode CIT base; high-tax countries lose revenue while low-tax countries gain taxable income inflows, possibly intensifying tax competition and reducing global welfare.
- Net assessment: welfare costs of debt bias are probably substantial and likely exceed traditional deadweight loss estimates that ignore externalities, cyclical amplification, and arbitrage costs. For financial institutions, externalities may justify taxing debt rather than favoring it.

### Possible policy responses — overview
- Two comprehensive reform directions to achieve neutrality:
  - Disallow interest deductibility (comprehensive business income tax, CBIT).
  - Introduce an allowance for corporate equity (ACE).
- Both eliminate tax discrimination between debt and equity but have different broader economic properties: CBIT aligns with Schanz-Haig-Simons comprehensive income taxation; ACE aligns with consumption-based frameworks that exempt normal returns.

### A. Restricting interest deductibility (options and implications)
- Thin capitalization rules:
  - Evidence: seem to have reduced debt ratios for intracompany debt (Overesch and Wamser, 2006; Weichenrieder and Windischbauer, 2008), but also appear to have reduced investment (Buettner et al., 2006).
  - Limitations: ad-hoc, avoidable via hybrids and definitional differences, lead to refinements and complexity.
- Interest deduction caps and inflation correction:
  - Options: cap deductible interest rate; allow deduction only for real interest; index depreciation allowances and losses, correct interest receipts for inflation.
  - Trade-off: reduces debt bias but increases complexity.
- Comprehensive Business Income Tax (CBIT):
  - Feature: denies interest deductibility; treats debt as current CIT regimes treat equity; consistent with firm-level taxation of all capital income and possible abolition of PIT on interest, dividends, and capital gains.
  - Effects:
    - Eliminates corporate finance distortions but raises cost of capital on debt-financed investments, reducing investment.
    - Broadens CIT base, permitting lower statutory CIT rate as part of revenue-neutral reform; benefits may accrue via inward profit shifting if the CBIT country lowers its CIT rate and others do not (de Mooij and Devereux, 2011).
    - Risks for banks and international banking: under CBIT, banks are disallowed deduction for interest expenses but not taxed on interest received from CBIT firms, effectively exempting traditional banking and shifting tax burden to non-financial firms; unilateral CBIT can distort international banking and lending markets; implementing CBIT faces practical and transitional obstacles (pre-existing debt, short-run amplification of financial distress).
  - Partial CBIT on intracompany debt:
    - Potential to mitigate multinational debt shifting by treating intracompany flows as equity, but requires international coordination; unilateral application may exacerbate debt shifting and cause double taxation concerns.
- No real-world full CBIT examples; practical implementation challenges and transitional issues noted.

### B. Allowance for Corporate Equity (ACE) and related approaches
- ACE fundamentals:
  - Supplements interest deductibility with deduction for notional return on equity; neutral with respect to debt-equity choice and marginal investment decisions.
  - By allowing deductions for both interest and normal equity return, ACE charges no tax on projects returning the cost of capital — taxes economic rents instead.
  - ACE offsets distortions from different economic vs tax depreciation because present-value of depreciation allowance plus ACE is independent of tax depreciation rate.
- ACC (Allowance for Corporate Capital):
  - Replaces interest deduction with deduction for notional risk-free return on all capital (debt and equity), achieving full neutrality and avoiding intracompany transfer pricing issues. Raises questions on tax treatment of interest income similar to CBIT.
- International and historical experience:
  - Countries that experimented: Croatia, Austria, Italy (around millennium change) — later terminated as part of CIT rate reduction reforms, not due to technical difficulties (Keen and King, 2002).
  - Contemporary adopters/variants: Brazil, Latvia, Belgium.
    - Belgium: notional deduction at 10-year government bond rate (between 3 and 4 percent in recent years); allowance applies to book value of net equity adjusted for equity participations; 2008 estimated allowances ≈ 6 billion euro and reduced corporate tax yield by slightly more than 10 percent.
    - Brazil: variant applies to distributed profit only (introduced 1996); primarily affected dividend payout ratios with small effects on investment and financial structure (Klemm, 2007).
    - Latvia: in 2010 introduced notional deduction on retained earnings; rate equals annual weighted average interest on loans to non-financial businesses.
- Fiscal cost and financing options:
  - Direct estimated revenue cost: approximately 15 percent of CIT revenue, or 0.5 percent of GDP on average (appendix estimation for 15 developed countries).
  - Cost depends on ACE rate and definition of base; estimated narrowing of CIT base ranges from 7 percent (Norway) to almost 20 percent (Australia); direct fiscal cost between 0.25 and 1.0 percent of GDP.
  - Options to reduce short-run fiscal cost:
    - Apply ACE only to new investment to avoid windfall gains on existing capital.
    - Impose special taxation on debt in financial sector to offset revenue loss.
    - Integrate ACE in an income tax framework (e.g., Business Enterprise Income Tax, BEIT) or as part of an expenditure tax financed by higher VAT.
  - Simulation evidence (ACE financed by higher VAT to close government budget):
    - de Mooij-Devereux (EU): Debt-asset ratio (absolute change) −4.7; Investment 5.9 percent; Employment 0.4 percent; GDP 1.9 percent.
    - Keuschnigg-Dietz (Switzerland): Debt-asset ratio (absolute change) −3.8; Investment 7.8 percent; Employment 0.4 percent; GDP 2.6 percent.
    - Radulescu-Stimmelmayr (Germany): Debt-asset ratio n.a.; Investment 20.5 percent; Employment 1.7 percent; GDP 9.1 percent.
    - De Mooij and Devereux (2011) report that approximately three-quarters of the initial fiscal cost of ACE can be recovered in the long run via behavioral responses.
- Incidence: empirical evidence (Hassett and Mathur, 2006; Arulampalam and others, 2010) suggests workers bear a large share of CIT incidence; ACE likely benefits employees through higher wages.

### Empirical appendix: estimated direct revenue impact of ACE (selected figures)
- Method: Worldscope data for years 2005–07; ACE base = book value of equity minus unconsolidated subsidiaries; ACE allowance = equity base × 10-year government bond yield (average 2005–07); loss-making firms assumed ACE = one-half value; aggregates expressed as percentage reduction of business tax base and then converted to percent of GDP by multiplying reduction in business tax revenue by CIT-to-GDP ratio.
- Table 3 selected country estimates (Sample, Average ACE Rate, Company Tax Base reduction, Revenue effect in percent GDP):
  - UK: 4703, 4.6, − 17.4, − 0.56
  - France: 1502, 3.9, − 15.1, − 0.48
  - Canada: 2695, 4.3, − 19.3, − 0.48
  - Australia: 4018, 5.6, − 20.5, − 0.95
  - Belgium: 293, 3.9, − 16.7, − 0.60
  - Netherlands: 360, 3.8, − 9.8, − 0.34
  - Norway: 397, 4.0, − 7.0, − 0.28
  - Sweden: 827, 3.8, − 12.8, − 0.51
  - Denmark: 389, 3.8, − 12.9, − 0.52
  - Finland: 305, 3.8, − 13.5, − 0.53
  - Italy: 733, 4.0, − 12.6, − 0.40
  - Spain: 362, 3.8, − 10.6, − 0.51
  - Germany: 1729, 3.8, − 16.1, − 0.40
  - U.S.: 11833, 4.6, − 17.5, − 0.43
  - Japan: 7004, 1.6, − 9.4, − 0.38
  - Average: (no sample), 4.0, − 14.1, − 0.49
- Caveats: true ACE cost may differ due to differences between equity in tax vs commercial accounts and sample representativeness; example—true Belgian cost ≈ 10 percent of CIT revenue while sample estimate suggests 16 percent. ACE may apply to corporate and non-corporate firms; CIT-to-GDP adjustments made for Germany.

### Policy conclusions and recommendations
- No compelling legal, administrative, or economic reason to systematically favor debt over equity; debt bias exists and warrants policy attention given likely substantial welfare costs amplified by financial-sector externalities, business-cycle effects, and tax arbitrage.
- Reform pathways:
  - Disallowing interest deductibility (CBIT) eliminates debt bias but has drawbacks (bank under-taxation, international distortions, transitional issues).
  - Partial denial focused on intracompany interest could mitigate multinational debt shifting but requires coordination.
  - Most promising: introduction of an ACE, with design options to limit short-run fiscal cost (apply only to new investment, offset with banking-sector debt taxes, combine with BEIT or VAT financing).
- Complementary measure: penalize debt financing in sectors with large externalities (e.g., financial sector) via higher taxes on debt to correct systemic-risk externalities.
- Budgetary and political attractiveness: an ACE combined with sectoral debt penalties shifts tax burden from desirable behavior (new investment) to harmful behavior (excessive debt), helping contain fiscal cost.

*Source: Box 1. Optimal Capital Structure in Corporate Finance Models — _sdn1111 (IMF).*

### References

### _sdn1111 - References

### Major thematic clusters in the references
- Corporate taxation design and neutrality
- Debt bias, thin-capitalization, and corporate use of debt
- Bank capital structure and financial-sector taxation
- Investment, capital-market imperfections, and corporate finance theory
- Policy responses to the 2008 financial crisis and tax-policy implications

### References grouped by theme

- Corporate taxation design and neutrality
  - Altshuler, R., and A.J. Auerbach, 1990, ―The Significance of Tax Law Asymmetries: An Empirical Investigation,‖ Quarterly Journal of Economics Vol. 105 pp. 61–86.
  - Boadway, R., and N. Bruce, 1984, ―A General Proposition on the Design of a Neutral Business Tax,‖ Journal of Public Economics, Vol. 24, pp. 231–39.
  - Devereux, M.P., and H. Freeman, 1991, ―A General Neutral Profits Tax,‖ Fiscal Studies, Vol. 12, pp. 1–15.
  - Keen, M., and J. King, 2002, ―The Croatian Profit Tax: An ACE in Practice,‖ Fiscal Studies, Vol. 23, pp. 401–18.
  - Klemm, A., 2007, ―Allowances for Corporate Equity in Practice,‖ CESifo Economic Studies Vol. 53, pp. 229–62.
  - Kleinbard, E., 2007, ―Designing an Income Tax on Capital,‖ in Taxing Capital Income, ed. by H.J. Aaron, L. Burman, and E. Steuerle (Washington: Urban Institute Press).
  - Mirrlees, J.A., S. Adam, T. Besley, R. Blundell, S. Bond, R. Chote, M. Gammie, P. Johnson, G. Myles, and J. Poterba, 2011, Tax by design (London: Institute for Fiscal Studies).
  - Meade, J., 1978, ―The Structure and Reform of Direct Taxation‖ (London: Institute for Fiscal Studies).
  - Institute for Fiscal Studies, 1991, ―Equity for Companies: A Corporation Tax for the 1990s,‖ (London).
  - Bond, S.R., 2000, ―Levelling Up or Levelling Down? Some Reflections on the ACE and CBIT Proposals and the Future of the Corporate Tax Base‖, in Taxing Capital Income in the European Union, ed. by S. Cnossen (Oxford: Oxford University Press).
  - de Mooij, R.A., and M.P. Devereux, 2011, ―An Applied Analysis of ACE and CBIT Reforms in the EU,‖ International Tax and Public Finance, Vol. 18, No. 1, pp. 93–120.
  - Radulescu, D.M., and M. Stimmelmayr, 2007, ―ACE versus CBIT: Which is Better for Investment and Welfare?,‖ CESifo Economic Studies, Vol. 53, pp. 294–328.

- Debt bias, thin-capitalization, and corporate use of debt
  - de Mooij, R.A., 2011, ―The Tax Elasticity of Corporate Debt: A Synthesis of Size and Variations,‖ Working Paper (Washington: International Monetary Fund)
  - Buettner, T., M. Overesch, U. Schreiber, and G. Wamser, 2006, The Impact of Thin-Capitalization Rules of Multinationals’ Financing and Investment Decisions, CESifo Working Paper 1817 (Munich: University of Munich).
  - Overesch, M., and G. Wamser, 2006, ―German Inbound Investment, Corporate Tax Planning, and Thin-Capitalization Rules—A Difference-in-Differences Approach,‖ CESifo Working Paper 37 (Munich: University of Munich).
  - Weichenrieder, A., and T. Klautke, 2008, ―Taxes and the Efficiency Costs of Capital Distortions,‖ CESifo Working Paper 2431 (Munich: University of Munich).
  - Weichenrieder, A., and H. Windischbauer, 2008. ―Thin-Capitalization Rules and Company Responses Experience from German Legislation,‖ CESifo Working Paper 2456 (Munich: University of Munich).
  - Gordon, R.H., and A.L. Bovenberg, 2010, ―Taxation and Corporate Use of Debt: Implications for Tax Policy,‖ National Tax Journal, Vol. 63, pp. 151–74.
  - Gravelle, J.C., 2010, ―Corporate Tax Incidence: Review of General Equilibrium Estimates and Analysis,‖ Congressional Budget Office Working Paper 2010-03, Washington DC.

- Bank capital, financial-sector taxation, and crisis-related tax issues
  - Berger A., R. DeYoung, M. Flannery, D. Lee, and O. Oztekin, 2008, ―How Do Large Banking Organizations Manage Their Capital Ratios?,‖ Journal of Financial Services Research, Vol. 34, pp. 123–49.
  - Flannery M., and K. Rangan, 2008, ―What Caused the Bank Capital Build-Up of the 1990s?‖ Review of Finance, Vol. 12, pp. 391–429.
  - Gropp, R., and F. Heider, 2010, ―The Determinants of Bank Capital Structure,‖ Review of Finance, first published online March 30, 2010 http://rof.oxfordjournals.org/content/early/recent
  - Claessens, S., M. Keen, and C. Pazarbasioglu, 2010, ―Financial Sector Taxation: The IMF’s Report to the G-20 and Background Material,‖ (Washington: International Monetary Fund).
  - International Monetary Fund, 2009, ―Debt Bias and Other Distortions: Crisis-related Issues in Tax Policy‖ (Washington: International Monetary Fund).
  - International Monetary Fund, 2010, ―A Fair and Substantial Contribution by the Financial Sector: Final Report for the G-20,‖ Staff Paper (Washington: International Monetary Fund).
  - Hemmelgarn, T., and G. Nicodème, 2010, ―The 2008 Financial Crisis and Tax Policy,‖ Working Paper 20, European Commission Directorate-General for Taxation and Customs Union, Brussels.
  - Lloyd, G., 2009, ―Moving Beyond the Crisis: Using Tax Policy of Support Financial Stability,‖ (unpublished, Paris: OECD).
  - Slemrod, J., 2009, ―Lessons for Tax Policy in the Great Recession,‖ National Tax Journal, Vol. 62, pp. 387–97.
  - U.S. Department of Treasury, 1992, ―Integration of the Individual and Corporate Tax System: Taxing Business Income Once‖ (Washington: U.S. Government Printing Office).

- Investment, capital-market imperfections, and corporate finance theory
  - Modigliani, F., and M. Miller, 1958, ―The Cost of Capital, Corporation Finance and the Theory of Investment,‖ American Economic Review, Vol. 48, No. 3, pp. 261–97.
  - Myers, S.C., and N.S. Majluf, 1984, ―Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have,‖ Journal of Financial Economics, Vol. 13, pp. 187–221.
  - De Meza, D., and D. Webb, 1987, ―Too Much Investment: A Problem of Asymmetric Information,‖ Quarterly Journal of Economics, Vol. 102, pp. 281–92.
  - Hubbard, R.G., 1997, ―Capital-market Imperfections and Investment,‖ NBER Working Paper 5996 (Cambridge, Massachusetts: National Bureau of Economic Research).
  - Jensen, M.C., 1986, ―Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,‖ American Economic Review, Vol. 76, pp. 323–29.
  - Easterbrook, F.H., 1984, ―Two Agency-Cost Explanations of Dividends,‖ American Economic Review, Vol. 74, No. 4, pp. 650–59.
  - Ross, S.A., 1977, ―The Determinants of Financial Structure: the Incentive-signaling Approach,‖ Bell Journal of Economics, Vol. 8, pp. 23–40.
  - Tirole, J., 2006, The Theory of Corporate Finance (Princeton: Princeton University Press).
  - Shaviro, D.N., 2009, Decoding the U.S. Corporate Tax (Washington: Urban Institute).
  - Smith, C.W., 1986, ―Investment Banking and the Capital Acquisition Process,‖ Journal of Financial Economics, Vol. 15, pp. 3–29.
  - Stiglitz, J., and A. Weiss, 1981, ―Credit Rationing in Markets with Imperfect Information,‖ American Economic Review, Vol. 71, pp. 393–410.
  - Gordon, R.H., and A.L. Bovenberg, 1996, ―Why is Capital So Immobile Internationally? Possible Explanations and Implications for Capital Income Taxation,‖ American Economic Review, Vol. 86, pp. 1057–75.

- International tax competitiveness and effective tax rates
  - ZEW and Oxford University Centre for Business Taxation, 2008, ―Effective Tax Rates on Investments in the EU, 1998–2007,‖ Report for the European Commission.
  - Fidora, M., M. Fratzscher, and C. Thimann, 2006, ―Home Bias in Global Bond and Equity Markets: The Role of Real Exchange Rate Volatility,‖ ECB Working Paper 685 (Frankfurt: European Central Bank).
  - Keuschnigg, C., and M.D. Dietz, 2007, ―A Growth Oriented Dual Income Tax,‖ International Tax and Public Finance, Vol. 14, pp. 191–221.
  - Keuschnigg, C., E. Ribi, 2010, ―Business Taxation, Corporate Finance and Economic Performance,‖ (unpublished, University of St. Gallen, Switzerland).
  - Hassett, K. A., and Mathur, A., 2006, ‖Taxes and Wages,‖ American Enterprise Institute, unpublished, Washington, DC.
  - Gordon, R.H., 2010, ―Taxation and Corporate Use of Debt: Implications for Tax Policy,‖ National Tax Journal, Vol. 63, pp. 151–74.

### Observations implied by the collected references
- Significant scholarly attention is focused on neutral business tax design (ACE, CBIT, profit-neutral taxes) and practical country experiences.
- Debt bias, thin-capitalization rules, and tax elasticity of corporate debt are recurring empirical and policy concerns.
- Financial-sector taxation and the role of tax policy in response to the 2008 financial crisis are treated in multiple IMF, OECD, and EU studies.
- Classic corporate finance theory and agency/information-friction models underpin many applied analyses of investment and financing responses to tax policy.

*References list as given in the source PDF.*

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