Should Companies Borrow More When Tax Rates Are High?

Conventional wisdom in finance holds that higher corporate tax rates make debt more attractive for companies. When deciding whether to finance investments by borrowing money or by raising equity from shareholders, debt can be cheaper.

“Interest on debt is tax deductible,” said John Graham, the D. Richard Mead, Jr. Family Professor at Duke University’s Fuqua School of Business. “If I'm a company that pays $100 worth of interest, when I use debt, I save $100 multiplied by my tax rate in taxes, whereas if I paid $100 in equity dividends, none of it is tax deductible.”

So, what if the top corporate tax rate returned to before the 2017 Tax Cuts and Jobs Act (TCJA) — from today’s 21% back to 35%? Would every company suddenly start borrowing more?

Yes, but with an important distinction, according to new research by Graham and co-authors — Hyunseob Kim of Chicago Fed, Mark Leary of Washington University in St. Louis, and YoungJun Song of San Diego State University, all Fuqua PhDs.

The researchers examined nearly a century of company and tax data of U.S. public companies and found that companies don’t instantly adjust their debt levels whenever tax rates change.

Instead, they respond when they are already financing a major investment or expansion. Those financing points—not tax changes alone—determine when higher tax rates push firms toward assuming more debt.

And the effect is strongest among profitable companies that expect to continue to be profitable in the years to come, because they have more to gain from the tax deduction.

Debt versus equity

When companies need money to finance investments, they rely on internal or external sources: cash already on their balance sheet (internal), debt, or new equity from shareholders (both external). 

Once a company has exhausted its cash, the choice comes down to borrowing from lenders or raising money from shareholders. 

That is where the tax treatment of debt plays a role. Interest payments on corporate debt are generally tax deductible, meaning they reduce a company's taxable income. Dividends paid to shareholders do not receive the same treatment—they are paid from after-tax profits.

“All else equal, that means the company has more cash flow if they fund with debt relative to funding with equity,” Graham said.

The interest tax deduction increases disposable income, while dividends fully reduce it. This makes debt a less expensive way of financing investment, particularly when corporate tax rates are high.

Graham's research shows that U.S. public companies fund roughly 30% to 36% of their investment through debt.

100 years of data

To test whether taxes influence corporate borrowing, Graham and his co-authors analyzed nearly a century of financial information from U.S. public companies, spanning from the late 1920s through 2023. 

That long historical perspective allowed the researchers to examine two of the largest corporate tax increases in U.S. history—during World War II and the Korean War—which had mostly been absent from previous research. Those larger tax hikes provided a clearer test of whether companies respond to stronger tax incentives. 

The results confirmed that they do, but only under specific conditions. Higher tax rates led companies to finance more of their investments with debt when they were already raising external capital for major investments or expansions. Companies that were not actively financing new investment showed little evidence of changing their capital structure simply because tax rates increased. 

“The company waits until it next needs external funds,” Graham said. “Because if the company rushes to issue debt immediately after the tax rates increase, it would have to pay transaction costs to investment bankers and others. But, if it waits until it needs funds to invest, it was going to have to pay those fees anyway.”

The researchers also found that the response was strongest among firms with the greatest need for external financing. Companies with limited cash (internal funds) relied more heavily on debt than firms that could finance investment with their own cash.

Furthermore, the co-authors examined the behavior of companies with the highest incentive to borrow, based on Graham’s study of Marginal Tax Rates (MTR).

What is a Marginal Tax Rate?

Not every company benefits equally from the tax deductibility of interest. A business that pays no or little taxes has much less to gain from deducting interest expense than one with a large tax bill. Conversely, a business that is profitable and expects to be profitable in the future will benefit more from the interest deductions in future years.

“The more profitable you are, the more beneficial the interest deduction. At the extreme, if you're not profitable at all, the interest deduction doesn't do you any good at the present time,” Graham said.

His marginal tax rate indicator captures the present value (i.e., the value in today’s dollars) of expected tax savings that are expected to be used in the future. To do this, the Graham marginal tax rates consider the company’s expected future earnings, along with other features (such as loss carryforwards).

Graham pioneered this approach decades ago. For the current study, the research team extended those estimates across nearly a century of U.S. public companies, making it possible to compare how firms with different tax incentives respond to changes in tax policy. 

“Let’s consider a manager at IBM in the year 2000—when analyzing historic data, we want to know what that person was thinking in the year 2000 about IBM’s future,” he said. “Because if they issue debt, they'll be paying tax-deductible interest in the future years. Therefore, using historic data up to 2000, we create possible scenarios of what might happen in the future for IBM. One might be a good scenario—big profits—and others might include a medium scenario and a bad scenario. We calculate the probability that each of those scenarios might occur, and what the tax benefit from interest deductions would be should a given scenario occur. We then take a weighted average to determine the expected tax benefit from issuing debt in 2000 to obtain interest deductions.”

The researchers found that companies with higher marginal tax rates—those that stood to save the most from interest deductions—were significantly more likely to finance investment with debt when tax rates were high.

In short, companies don't all respond to tax policy in the same way. The firms with the greatest potential tax savings are also the ones most likely to act on those incentives when a financing opportunity arises. 

Why timing matters for borrowing

This research suggests that companies shouldn't think of debt simply as a tax-saving tool, but rather as a way to finance growth, Graham said.

The best time to adjust a company's capital structure is when it is already raising external financing for a major investment, acquisition, or expansion. At those moments, the cost of changing the mix of debt and equity is relatively low because the company is accessing capital markets anyway. 

That also implies a different approach during quieter periods. Rather than continuously increasing borrowing to maximize the tax deduction, companies should preserve debt capacity for when growth opportunities arise. This is the time when the tax advantages of debt are most valuable, Graham said.

The findings show that profitable, growing firms have more to gain from the interest deduction. The current wave of debt issuance by the so-called hyperscalers shows that rapidly growing companies making extraordinary investments still benefit from the interest deduction, despite today’s relatively low corporate tax rate, Graham said.

“You might think, well, 21% is so low. Do I still care about tax deduction? I think the answer is yes. Companies care a lot about taxes and try to be tax efficient, even in this era of relatively low corporate tax rates,” he said.