THE IMPACT OF FEDERAL TAXES ON THE USE OF DEBT BY CLOSELY HELD CORPORATIONS

It is often asserted that the income tax encourages the use of debt because of the deductibility of interest expense. We examine this conjecture by analyzing the interest incurred by a large sample of small, closely held corporations. We estimate regressions of the level of interest on proxies for expected future tax rates, interactions between the tax rate proxies and nondebt tax shields, and other determinants of debt utilization. Our evidence is consistent with prior studies in that we find that firms with high tax rates pay more interest than firms with low tax rates. In addition, firms for which additional tax shields might reasonably lower tax rates exhibited significant substitution between nondebt tax shields and debt tax shields.