Financial leverage and corporate taxationEvidence from German corporate tax return data

We estimate the impact of effective profit taxation on the financial leverage ofcorporations on the basis of a pseudo-panel constructed from corporate tax return micro data for theperiod 1998-2001, a period which saw the introduction of a major corporate tax reform in Germany.The financial leverage is measured by the ratio of long-term debt to total capital. Endogeneity of theeffective corporate tax rate is controlled for by an instrumental variable approach. Our instrumentfor the observed effective tax rate is the counterfactual tax rate a corporation would face in aparticular period had there been no endogenous change of its financial structure. This counterfactualis obtained from a detailed microsimulation model of the corporate sector based on tax return microdata. We find a statistically significant and relatively large positive effect of the tax rate oncorporate leverage: on average, an increase of the tax rate by 10 percent would increase thefinancial leverage by about 5 percent. We also find that the debt ratio is less responsive for smallcorporations and for corporations that benefit from various other forms of tax shields, in particulardepreciation allowances and tax loss carry-forward. However, tax effects do not seem to depend onrisk, although the level of economic risk does affect corporate leverage.