Corporation’s Threshold for Debt: Implications for Policy Reforms toward Equity-Biased Corporate Tax System

Abstract

This study analyses the threshold for debt of corporations under the debt-bias corporate tax system. We adopt a contingent claim model of the corporation to reflect the incentive effect of the debt-bias corporate tax system. This framework is based on aspiration level theory and the required probability for the successful completion of a project that is identical to decision weight probability in prospect theory. The proposed framework incorporates the debt-bias tax regulations prevailing in Organization for Economic Co-operation and Development (OECD) countries. When the OECD countries’ financial and non-financial corporation data were applied into framework, we observe that the government achieve equilibrium by employing contradictory corporate tax regulations. Moreover, we observe that corporations are intrinsically equity-loving, although the debt-bias corporate tax system stimulates corporations toward debt. This situation makes the government corporate revenue sensitive by placing it at the disposal of corporations’ financing choice instead of corporate profitability. The corporations’ threshold for debt assists in distinguishing between debt and equity-loving corporations. Moreover, corporations’ threshold for debt assists policy makers in deciding the appropriate combination of such reform policies as the Allowance on Corporate Equity and Comprehensive Business Income Tax. A transition from debt-oriented capital structure to equity-oriented capital structure may play an important role in promoting Islamic finance.

Citation

Shah, S.M. and Abdul-Majid, M. (2018), "Corporation’s Threshold for Debt: Implications for Policy Reforms toward Equity-Biased Corporate Tax System", Hassan, M.K. and Rashid, M. (Ed.) Management of Islamic Finance: Principle, Practice, and Performance (International Finance Review, Vol. 19), Emerald Publishing Limited, Leeds, pp. 145-173. https://doi.org/10.1108/S1569-376720180000019008