Taxes and Financial Frictions: Implications for Corporate Capital Structure

According to data from Compustat, we observe three general trends between 1980 and 2012. First, firms have been reducing their reliance on debt, as leverage ratios have fallen and an increasing fraction of firms are now actually net lenders. Second, the frequency at which firms neither issue external equity nor distribute dividends to shareholders has fallen. Third, marginal corporate income tax rates have fallen significantly as well. Using Compustat balance sheet data, we structurally estimate a model in which heterogeneous firms finance investment with equity and debt. Our model incorporates costly external finance as well as a detailed tax structure, including personal, dividend and corporate income taxes. We conclude that there has been a significant reduction in the cost of external equity, while overall leverage ratios have fallen mainly because of a lower tax advantage of debt.