Empirical Evaluation of Interest Barrier Effects

We analyze the impact of changes in thin capitalization rules on corporations' capital structure. Thin capitalization rules prevent rms from deducting excessive interest expenses from their tax base. As of 2008, Germany has severely changed its thin capitalization rule by targeting interest payments instead of debt to equity ratios. The new rule has primarily been introduced to prohibit tax avoidance by multinationals. For reasons of non-discrimination, the rule is, however, equally attributable on the national level and it is applicable to both internal and external nancing. The theoretical and analytical literature has brought forward many arguments stating that the new interest barrier is harmful to rms, distorting their nancing decisions. Four years after its introduction, the time has come to empirically evaluate the interest barrier. The DAFNE database serves as our source of reference. We di erentiate by rm characteristics, by industry and by kind of debt. We nd that the interest barrier drove rms to lower their debt to assets ratios and their net interest payments. Opposing its original intention, it was, however, also the national rms which adjusted their capital structure, and it was external rather than internal debt which was reduced. Thus, the interest barrier does indeed a ect nancing decisions, but predominantly not in the intended way and not of the intended rms. In sensitivity analyses we examine highly leveraged and low pro table rms, which are likely to be subject to the interest barrier. The results suggest a debt-reducing interest barrier e ect for these companies as well.