The Trade-Off and the Pecking-Order Empirical Effects of Corporate Taxation on Financial Choices: an Overall Assessment?

Although the interaction between taxation and corporate finance decisions has been widely studied, empirical findings show conflicting results so far. Different outcomes may be ascribed to differences in the theoretical models, in the definition of the variables of interest, in the source of variability of data (across firms and over time), and in the econometric methods. The aim of this paper is to assess the relationship between fiscal variables and corporate debt choices by tackling any cause of differences listed above. We can do this thanks to the availability of a large and very detailed data-set on Italian manufacturing companies over a long period with quite a lot of changes in the tax legislation. We find that both the relative price of debt and equity finance (the trade-off fiscal effect) and the net-of-tax cash flow (the pecking-order fiscal effect) are significant and robust ways through which corporate taxation affects financing decisions. Non-debt tax shields (another trade-off fiscal effect) are also important in explaining borrowing. The time dimension of data plays a substantial role in modelling the dynamic relationships and in giving variability to cost of capital data. In this context, various OLS estimation methods usually employed by the empirical literature are not consistent; we suggest the use of IV or GMM depending on the sample size.