Debt, Leases, Taxes, and the Endogeneity of Corporate Tax Status

Authors

  • John R. Graham,

    1. Fuqua School of Business, Duke University
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  • Michael L. Lemmon,

    1. College of Business, Arizona State University
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  • James S. Schallheim

    1. David Eccles School of Business, The University of Utah
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    • Graham is from the Fuqua School of Business, Duke University, Schallheim is from the David Eccles School of Business, The University of Utah, and Lemmon is from the College of Business, Arizona State University. We thank Jennifer Babcock, Hank Bessembinder, Charles Cuny, Eugene Fama, Avner Kalay, Uri Loewenstein, Stewart Myers, Mitch Petersen, Steven Sharpe, Terry Shevlin, Alex Triantis, and seminar participants from the 1997 American Finance Association conference, the Arizona Finance Symposium, the National Bureau of Economic Research, Duke, Penn State, Vanderbilt, and the Universities of Maryland, Utah, and Virginia for helpful comments. We also thank Rene Stulz (the editor) and an anonymous referee for detailed suggestions. All errors are our own. The simulated tax rates used in this paper (or an updated version thereof) can be found in a file on Graham's home page, http://www.duke.edu/~jgraham, or on the Journal of Finance home page.

Abstract

We provide evidence that corporate tax status is endogenous to financing decisions, which induces a spurious relation between measures of financial policy and many commonly used tax proxies. Using a forward-looking estimate of before-financing corporate marginal tax rates, we document a negative relation between operating leases and tax rates, and a positive relation between debt levels and tax rates. This is the first unambiguous evidence supporting the hypothesis that low tax rate firms lease more, and have lower debt levels, than high tax rate firms.

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