Analytical and Empirical Evidence of the Impact of Tax Rates on the Trade-Off between Debt and Managerial Ownership

Posted: 30 Aug 2001

See all articles by Zane L. Swanson

Zane L. Swanson

University of Central Oklahoma

Ananth Seetharaman

Saint Louis University - Department of Accounting

Bin Srinidhi

University of Texas at Arlington - Department of Accounting; City University of Hong Kong (CityUHK) - Department of Accountancy

Abstract

We show that, for a firm facing a high marginal tax rate, the benefit of using debt relative to managerial ownership to control agency costs increases at a decreasing rate. Debt and managerial stock ownership represent alternative mechanisms for reducing agency costs of the relationship between owner-investors and managers in firms. However, although debt and managerial ownership provide overlapping benefits, only debt can provide the differential benefit of reducing the firm's tax liability. While the tax benefit from using debt relative to managerial ownership to control agency conflicts is an increasing function of the firm's marginal tax rate, the decreased managerial ownership results in external investors bearing a larger part of the cost of debt that accrues to the firm. Effectively, for external investors, the relative cost of debt decreases at a decreasing rate when the marginal tax rate increases. Therefore, the trade-off between debt and managerial ownership predicted by the agency literature is expected to be strong at low marginal tax rates, but get progressively weaker at higher marginal tax rates. In this paper, we build an analytical model of this hypothesis and provide strong empirical evidence in its support. Our study contributes to a further understanding of how tax rates might affect the interaction of capital structure decisions with the incentive compatibility issues and corporate governance. The study also provides a basis for future studies to examine factors other than tax rates that differentially affect debt and managerial ownership costs.

Keywords: Marginal tax rate, Managerial ownership, Debt

JEL Classification: M41, G32, H25

Suggested Citation

Swanson, Zane L. and Seetharaman, Ananth and Srinidhi, Bin, Analytical and Empirical Evidence of the Impact of Tax Rates on the Trade-Off between Debt and Managerial Ownership. Available at SSRN: https://ssrn.com/abstract=274794

Zane L. Swanson (Contact Author)

University of Central Oklahoma ( email )

100 North University Drive
Edmond, OK 73034
United States

Ananth Seetharaman

Saint Louis University - Department of Accounting ( email )

3674 Lindell Blvd.
St. Louis, MO 63108
United States
314-977-2473 (Phone)
314-977-1473 (Fax)

Bin Srinidhi

University of Texas at Arlington - Department of Accounting ( email )

Arlington, TX 76013
United States

City University of Hong Kong (CityUHK) - Department of Accountancy ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong
China

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Abstract Views
1,350
PlumX Metrics