Tax Code Revision and The Value of Tax-Deductible Debt

Abstract

This paper examines a tax policy change that would eliminate the interest expense as a tax-deductible item for businesses. We analyze this change using a tax revenue neutral setting in a Modigliani-Miller world. The analysis uses two scenarios to compare the change to the present U.S. Tax Code. Scenario one assumes a non-competitive environment with sticky prices. Scenario two assumes that companies or industries with low leverage would cut prices instead of realizing excess profits. The reduction in prices will redistribute the present value of the corporate tax shield from the stockholder to the consumer. Using the Modigliani-Miller methodology for valuation, the maximum value (equivalent to theoretical value in this case) of the tax shield is approximately $712 billion. The actual value is probably less than half the theoretical amount. Under either scenario, the weighted average cost of capital increases for levered firms.