A Simple Economics of Capital Structure under Taxation Based on Consumption Smoothing

Abstract

This paper examines how the entrepreneur makes an optimal choice of capital structure under various assumptions on risk attitude and tax systems. Under a tax system putting equity at a disadvantage, it is demonstrated that if the preferential treatment of tax for debt is not so great, then the risk-averse entrepreneur who is borrowing from risk-neutral investors opts for a capital structure which includes both debt and equity. This result is shown to remain true in contracts with a single risk-averse investor. The reason is that the entrepreneur, being a risk-averse residual claimant, is willing to smooth consumption at the cost of tax. The risk-neutral entrepreneur chooses pure debt. With equity at a tax advantage, the risk-averse entrepreneur chooses pure equity. This paper also considers asymmetric information. The following results are established for the risk-averse entrepreneur and risk-neutral investors. In the separating equilibrium, if equity is at a tax disadvantage, then the more able entrepreneur selects a higher debt-equity ratio; if equity is tax-favored, then the more able entrepreneur offers outside equity holders a smoother (contingent) repayment schedule. This reflects the fact that by bearing more loss of consumption smoothing, the more able entrepreneur can separate himself from the less able entrepreneur. In the pooling equilibrium, the above results obtain for the less able entrepreneur. In general, hence, the repayment schedule becomes smoother in some sense under asymmetric information.