How Big Are the Tax Benefits of Debt?


  • John R. Graham

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    • Graham is at the Fuqua School of Business, Duke University. Early conversations with Rick Green, Eric Hughson, Mike Lemmon, and S. P. Kothari were helpful in formulating some of the ideas in this paper. I thank Peter Fortune for providing the bond return data and Eli Ofek for supplying the managerial entrenchment data. I also thank three referees for detailed comments; also, Jennifer Babcock, Ron Bagley, Alon Brav, John Campbell, John Chalmers, Bob Dammon, Eugene Fama, Roger Gordon, Mark Grinblatt, Burton Hollifield, Steve Huddart, Arvind Krishnamurthy, Rich Lyons, Robert MacDonald, Ernst Maug, Ed Maydew, Roni Michaely, Phillip O'Conner, John Persons, Dick Rendleman, Oded Sarig, René Stulz (the editor), Bob Taggart, S. Viswanathan, Ralph Walkling, and Jaime Zender; seminar participants at Carnegie Mellon, Chicago, Duke, Ohio State, Rice, the University of British Columbia, the University of North Carolina, Washington University, William and Mary, and Yale; seminar participants at the NBER Public Economics and Corporate workshops, the National Tax Association annual conference, the American Economic Association meetings, and the Eighth Annual Conference on Financial Economics and Accounting for helpful suggestions and feedback. Jane Laird gathered the state tax rate information. All errors are my own. This paper previously circulated under the title “tD or Not tD? Using Benefit Functions to Value and Infer the Costs of Interest Deductions.”


I integrate under firm-specific benefit functions to estimate that the capitalized tax benefit of debt equals 9.7 percent of firm value (or as low as 4.3 percent, net of personal taxes). The typical firm could double tax benefits by issuing debt until the marginal tax benefit begins to decline. I infer how aggressively a firm uses debt by observing the shape of its tax benefit function. Paradoxically, large, liquid, profitable firms with low expected distress costs use debt conservatively. Product market factors, growth options, low asset collateral, and planning for future expenditures lead to conservative debt usage. Conservative debt policy is persistent.