Taxes, financial distress, and capital structure in the United States and Japan

Abstract

In Study 1, I examine whether a U.S. firm's proximity to both financial distress and tax exhaustion affects whether debt is negatively related to non-debt tax shields. Effective tax planning requires a firm to consider both the tax and non-tax costs of its financing decisions. Financial distress costs are a non-tax cost of debt financing. Prior studies suggest that it is also important to account for a firm's proximity to tax exhaustion when examining whether taxes affect financing decisions. I find that debt is negatively related to non-debt tax shields for only non-financially distressed firms. The finding suggests that for financially distressed firms, the costs of financial distress outweigh the tax benefit of debt. The results also suggest that a firm's proximity to tax exhaustion does not affect the relation between debt and non-debt tax shields.In Study 2, I examine whether a Japanese firm's proximity to financial distress, keiretsu membership, and proximity to tax exhaustion affect whether debt is negatively related to non-debt tax shields. If financial distress costs are lower for keiretsu firms, financial distress should have a smaller effect on their financing decisions when compared to non-keiretsu firms, ceteris paribus. I find that debt is positively related to non-debt tax shields, regardless of financial distress, keiretsu membership, and tax exhaustion. Before concluding, I investigate explanations for why I find a positive relation in Japan; I also discuss explanations for why the results are inconsistent with prior studies that do find a negative relation.