Working Paper: NBER ID: w17920
Authors: Zhiguo He; Gregor Matvos
Abstract: We illustrate the welfare benefit of tax subsidies to corporate debt financing. Two firms engage in a socially wasteful competition for survival in a declining industry. Firms differ on two dimensions: exogenous productivity and endogenously chosen amount of debt financing, resulting in a two dimensional war of attrition. Debt financing increases incentives to exit, which, while socially beneficial, is costly for the firm. Therefore the planner can increase welfare by subsidizing debt financing. The duration of industry distress determines the tradeoff between the welfare benefit illustrated in our model and the costs of subsidizing corporate debt from the existing literature. Our theory also sheds light on why the IRS considers "conflict of interest" as one of the key determinants in identifying securities that are qualified for tax-benefits.
Keywords: debt; tax shield; capital structure; tax policy; war of attrition
JEL Codes: D82; G32; H25
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| subsidizing corporate debt (G32) | alleviating socially wasteful competition (D61) |
| debt financing (G32) | exit behavior of firms (D21) |
| debt financing (G32) | welfare outcomes (I38) |
| debt financing (G32) | exit times (C41) |
| increased debt subsidy (H63) | shorter exit times (C41) |
| debt subsidy (H63) | efficient resource reallocation (D61) |
| debt subsidy beyond a certain point (H63) | welfare-destroying (D69) |
| conflict of interest between equity and debt holders (G32) | socially desirable outcomes (D91) |