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8 Summary and suggestions for future research.

This paper reviews research related to how taxes affect corporate activities. The research often finds that taxes affect corporate financial decisions--but the magnitude of the effect is not always large.

With respect to capital structure, there is cross-sectional regression evidence that high-tax rate firms use debt more intensively than do low tax rate firms. There is also exchange offer evidence that indicates that debt tax benefits add to firm value. However, there is room for much additional research to improve our understanding of capital structure tax effects.

One gap is the lack of time-series evidence about whether firm-specific changes in tax status affect debt policy. Another important area for future research is to isolate the market value of the tax benefits of debt for the broad cross-section of firms. Additional research is also needed to explain the apparently conservative debt policy of many firms. Such analysis might investigate whether non-debt tax shields substitute for interest deductions--and help solve the "conservative leverage puzzle." Three such nondebt tax shields include employee stock option deductions, tax shelters, and accumulated foreign tax credits. Recent research indicates that the first two help to (partially) explain apparent underleverage in some firms. Keep in mind, though, that nondebt tax shields should only affect tax incentives to the extent that they affect the corporate marginal tax rate.

We have also only scratched the surface regarding tax-related leasing research. There is currently not much analysis of whether taxes affect the pricing and structure of lease (or other financial) contracts, analysis of whether leases and debt are substitutes for the lessee, or evidence about how lessor tax rates affect leasing. There is also little research into the effect of relative corporate and personal taxes on the aggregate demand and supply of debt. Unambiguous evidence about whether taxes affect debt maturity choices is also rare. Finally, all of this research should emphasize robust statistical treatment of standard errors and the economic importance of tax effects, in light of Myers et al. (1998) statement that taxes are of third-order importance in the hierarchy of corporate decisions.

Though intriguing in theory, the profession has made only modest progress documenting whether investor taxes affect asset prices and in turn affect the costs and benefits of corporate policies. There is strong evidence that personal taxes drive a wedge between corporate and municipal bond yields. There is also plausible evidence that the personal tax penalty on MIPs interest income is only modest, which might imply that the personal tax penalty on debt is only modest (relative to using equity)--but this implication needs to be verified. Several papers assume that companies have clienteles of investors that have similar tax characteristics, and then link these companies' policies to the assumed investor tax rates; however, it would be helpful to make these linkages more direct. In general, we need more market evidence about the importance of personal taxes affecting asset prices, the effective equity tax rate for the marginal investor(s), and information related to the identity of the marginal investor(s) between different securities. One level deeper, we also need evidence that corporate policies are altered in response to these investor tax influences on security prices. Some of this evidence will be hard to come by and might require access to confidential information or data from countries with unique data or institutional settings.

Progress has been made relating multinational tax considerations to corporate financing decisions, especially in terms of the use of debt by affiliated foreign entities when foreign tax rates are high. However, there is a need for research that highlights capital structure comparisons between classical and other tax systems and direct tests of multinational tax incentives, including the interaction of explanatory variables when appropriate (e.g., excess credit status interacted with interest allocation considerations). It would be helpful if excess (or deficit) credit tax position were measured more precisely than simply using current-period average tax rates.

Several studies link corporate payout policy to tax considerations. In particular, the ex-day stock return and volume evidence is consistent with investor tax considerations influencing asset markets. The Green and Rydqvist (1999) study of Swedish lottery bonds stands out in terms of presenting clean ex-day evidence documenting personal tax effects and serves as a model for future research that isolates tax effects. Unique insights into some payout issues might be provided by comparing payout policy in classical versus other tax systems. In addition, there currently is no convincing evidence that the interaction of investor tax characteristics and payout policy affect firm value and stock returns. Finally, there is a need for direct evidence that tax-based investor clienteles exist (i.e., that investors hold certain securities because of the investor's tax status and the form of payout) --because many of the payout hypotheses implicitly assume that such clienteles exist.

There is some recent evidence documenting tax motivated compensation payments (i.e., the choice between salary and options paid to non-executive employees), risk management (i.e., hedging to increase debt capacity and the tax benefits of debt), and earnings management. However, we need more "all parties, all deductions" research in these areas, as well as analysis of whether these forms of non-debt tax shields are substitutes for each other or for debt interest. We also need compensation studies based on firm- and employee-specific tax rates and the choice between ISO and NQO plans. Finally, to date there have been few direct tests of whether earnings management is related to progressive tax schedules, less than full valuation of accumulated NOLs and other deductions, and/or expectations of changes in future tax rates.

Some studies have documented that firms choose organizational form based on relative corporate and personal tax rates, that asset sales are structured in response to tax considerations, and that corporate bankruptcy and highly levered restructurings have tax implications. However, we need more evidence about the choice of corporate form using firm-specific data, evidence that firms choose ex ante to perform highly leveraged buyouts in response to tax incentives, and, in general, more evidence about tax incentives affecting corporate reorganizations, spinoffs, and other forms of restructuring.

Finally, while it is convenient for academic research to investigate these tax issues one by one, there is potential for large gains from investigating how these various policies and tax incentives interact from the perspective of a corporate financial manager or tax planner. Along these lines, some recent progress has been made investigating tax shelters. Additional studies that integrate the murky world of tax shelters into the overall tax planning environment would be helpful. Overall, there are numerous important areas in which careful research can contribute to our understanding of how the imperfections created by taxes affect corporate decisions and firm value.

John R. Graham, Fuqua School of Business, Duke University, Durham, NC 27708-0120 and NBER,
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Title Annotation:A Review of Taxes and Corporate Finance
Author:Graham, John R.
Publication:Foundations and Trends in Finance
Geographic Code:4EUUK
Date:Jan 1, 2006
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