“Corporate Taxation and its Reforms: Effects on Corporate Financing Decisions in Italy”

Corporate capital structure is one of the most studied areas of business decisions. Nevertheless, it continues to be one of the least understood and more difficult to quantify. In this line of research, there is a large body of work modelling the interaction between taxation and corporate financing decisions, but little support has been found in empirical analysis. In the Anglo-Saxon literature few research papers have found clear evidence of the effects of tax benefits on debt financing (Graham, 2003, for a review). Several problems arise in analysing the role of taxation on debt financing. First of all, it is difficult to translate the technical details of the tax code into a proper measure able to capture the relative tax benefits of debt versus equity finance. Various empirical approaches have been used to account for the interaction between tax rates, interest deductions, non-debt tax shields and the loss carry-back and -forward provisions. None of them, however, is completely satisfactory, also due to the lack of confidential firm-level tax return data. Second, fiscal variables are endogenous: for example, the greater the firm’s borrowing, the lower could be the effective tax benefit of interest deductions, since the tax advantage of debt declines as companies become tax-exhausted, and this could in fact be the case with growing interest payments. Third, fiscal and non fiscal variables are intra- and inter-correlated. Correlation among fiscal factors worsens the endogeneity problem: current operating losses, non debt tax deductions (loss carry forwards and depreciation allowances) and interest deductions from already existing debt may contribute, along with interest deductions on new debt, to increase the tax-exhaustion status of firms. Moreover, borrowing also depends on other factors correlated with tax status. If these factors are omitted from the model, this would impart biases to the fiscal parameter estimates. This paper has two objectives. The first is to provide a systematic quantitative analysis of the relationship between fiscal variables and borrowing in Italy, trying to tackle the problems outlined above. The empirical evidence on this issue is still relatively scarce in Italy 1 We are grateful to Vieri Ceriani and Jacques Mairesse for the comments on a first draft of this paper. The authors would also like to thank Capitalia Research Department for kindly providing the microdata and all the members of the Capitalia Scientific Board of the “Osservatorio per le piccole e medie imprese” for helpful and, as for other countries, cannot be considered conclusive (see e.g. Bonato-Faini-Ratti, 1993, Staderini, 2001, and Alworth-Arachi, 2001). The second aim is to use our framework to shed some light on the effects of tax policy changes on corporate financial policy. This is of particular relevance in the Italian case. Here, a tax reform was implement at the end of the 1990s with the main purpose of reducing the tax advantage to debt and stimulate firms’ capitalisation. Unfortunately, the reform was shortly reversed (in 2001), thus preventing the possibility to undertake a “natural experiment” test. Nevertheless, the analysis put forward in this paper can provide some useful indication of the effects on debt of these alternative reforms.