Debt Financing and Tax Status: Tests of the Substitution Effect and the Tax Exhaustion Hypothesis Using Firms' Responses to the Economic Recovery Tax Act of 1981

Authors

  • ROBERT TREZEVANT

    Search for more papers by this author
    • From School of Accounting at the University of Southern California. I would like to especially thank my dissertation chairman Dan S. Dhaliwal for his encouragement and insights, the anonymous referee, and the editor René Stulz. I further gratefully acknowledge funding from Tax Research Opportunities of the Peat Marwick Foundation.

ABSTRACT

This study tests the joint prediction of the substitution effect and the tax exhaustion hypothesis that an increase in non-debt tax shields leads to a decrease in leverage. Controls are introduced for the debt securability effect, the pecking order theory of financing, and the probability of losing tax shields. Using the relationship between changes in investment tax shields and changes in debt tax shields of firms in response to the Economic Recovery Tax Act of 1981, strong empirical support is found for predictions based on the substitution effect and the tax exhaustion hypothesis.

Ancillary