Corporate Income Tax (CIT) and Capital

Abstract

This research consists of verifying whether CIT has an effect on capital given the financing risk incurred. A review of several capital theories has shown that CIT is one of the main determinants of a firm's capital structure. The inclusion of CIT in capital structure models continues to divide the world of corporate finance. Debt interest deduction in computing CIT reinforces the controversy over the question of the capital structure that optimizes the tax savings provided by this deduction. The consequence is the existence of two opposing groups on the optimum capital structure: on the one hand, the group of those who believe that there is one and only one optimal capital structure, and on the other, the group of those who reject out of hand any possibility of an optimal capital structure.

The sample starts with a case study of two hypothetical identical firms, one indebted and the other non-indebted, with the same profitable investment project over a period of time, and ends with 101 pairs of identical firms belonging to different classes of financing risk. The hypothesis of non-gratuity of cost and income is used, and capital markets are assumed to be pure and perfect.

The results confirm that CIT has no effect on the structure, value, cost and return of capital for a given financing risk, and reveal the existence of a third source of financing called "public capital", whose cost is the corporate capital tax rate (CCTR). There is no longer any question of thinking about the optimum capital structure, which is a pure financial illusion. This paper is one of the first to show that CIT does not affect capital, and to propose a model that explains capital structure behavior in the presence of CIT.

Keywords: Capital structure; firm value; weighted average cost of capital (WACC); return on investment; financial integration of corporate tax.

JEL Classification: G32; G34; G38; H24; H26; H32

Paper type: Empirical Research