In the context of
corporate finance
Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to all ...
, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with
debt
Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...
than with
equity
Equity may refer to:
Finance, accounting and ownership
*Equity (finance), ownership of assets that have liabilities attached to them
** Stock, equity based on original contributions of cash or other value to a business
** Home equity, the diff ...
. Under a majority of
taxation systems around the world, and until recently under the
United States tax system, firms are taxed on their
profits and individuals are taxed on their
personal income
In economics, personal income refers to an individual's total earnings from wages, investment enterprises, and other ventures. It is the sum of all the incomes received by all the individuals or household during a given period. Personal income is ...
.
For example, a firm that earns $100 in profits in the United States would have to pay around $30 in taxes. If it then distributes these profits to its owners as
dividends
A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-in ...
, then the owners in turn pay taxes on this income, say $20 on the $70 of dividends. The $100 of profits turned into $50 of investor income.
If, instead the firm finances with debt, then, assuming the firm owes $100 of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $30. This implies for $100 of
profits before taxes, investors got $70.
Graham, John, "How big are the Tax Benefits of Debt" The Journal of Finance, 2000.
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This tax-related encouragement of debt financing has not gone uncriticized.[Richard T. Page]
"Foolish Revenge or Shrewd Regulation? Financial-Industry Tax Law Reforms Proposed in the Wake of the Financial Crisis?"
85 Tul. L. Rev.
The ''Tulane Law Review'', a publication of the Tulane University Law School, was founded in 1916, and is currently published five times annually. The Law Review has an international circulation and is one of few American law reviews carried by l ...
191 (2010). For example, some critics have argued that the cost of equity should also be deductible; which could reduce the Internal Revenue Code
The Internal Revenue Code (IRC), formally the Internal Revenue Code of 1986, is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 2 ...
's influence on capital-structure decisions, potentially reducing the economic instability attributable to excessive debt financing.
See also
*Trade-Off Theory
The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger ...
*Capital structure
In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in th ...
*Dividend tax
A dividend tax is a tax imposed by a jurisdiction on dividends paid by a corporation to its shareholders (stockholders). The primary tax liability is that of the shareholder, though a tax obligation may also be imposed on the corporation in the ...
References
{{debt
Corporate taxation
Debt