Simulating Corporate Marginal Income Tax Rates and Implications for Corporate Debt Policy

We study several important tax-related issues related to the measurement and use of corporate marginal tax rates. First, we develop an AR(1) method to simulate corporate marginal income tax rates and demonstrate that the AR(1) model improves upon the extant random walk and bin approaches. The new AR(1) approach captures firm-specific features, including mean-reversion in taxable income. Second, we calculate marginal tax benefit curves, which are the functions that determine the marginal tax rate for different levels of interest deduction. We integrate under tax benefit functions calculated using the AR(1), random walk, and bin approaches and find roughly similar implications for all methods, namely that the tax benefits of debt average about 13% of book asset value, gross of all costs. Third, we investigate the “kink” in benefit functions based on each of the three methods, that is, where the kink represents the point where marginal tax benefits begin to decline. The kink is sometimes used to infer how conservatively companies use debt. Our analysis indicates that implications about debt conservatism based on the AR(1) model are relatively robust to specification choices, while implications based on the bin model are sensitive to the specification. Overall, we find that all three models provide roughly similar implications about how aggressively companies appear to use debt once reasonable modifications are made to the debt conservatism metric. Importantly, controlling for a company’s interest usage, we find that variables commonly used to proxy for the costs of debt only partially explain that company’s kink (i.e., common cost variables only partially explain why some firms appear to use debt conservatively). We thank Alon Brav, Cam Harvey, Mark Leary, Per Olsson, Michael Roberts, Bob Winkler and the Texas Tax Reading Group for helpful feedback. Kim gratefully acknowledges financial support from the Kwanjeong Educational Foundation. Any errors are our own.