The Impact of Financial Constraints on the Relation between Investor-Level Taxes and Capital Structure Decisions

Abstract

This study addresses the question of whether the relation between investor-level taxes and a firm's capital structure decisions varies predictably with financial constraints. Using the setting of the 2003 reduction in individual tax rates for ordinary income, dividends, and capital gains, this study documents that constrained firms decrease their debt use in response to the 2003 tax cuts, while unconstrained firms increase their debt use over the same period. I find these effects are only evident among firms with relatively high individual ownership, which is the group of firms that theory suggests will react to the tax cuts. This paper contributes to the literature on how investor-level taxes influence firms' financing decisions as well as the literature pertaining to the 2003 Tax Act.