The Impact of Introducing an Interest Barrier: Evidence from the German Corporation Tax Reform 2008

In this study we investigate the impact of the thin capitalization rule (TCR), introduced in Germany in 2008, on firms' capital structure, investment and profitability. The identification of the causal effects is based on the escape clauses in the regulation using a difference-in-difference approach. Our results present evidence that firms strongly react in order to avoid the limited deductibility of interest expenses: They either decrease their debt ratio or split their assets to use the exemption limit. The latter is especially used by firms with an interest result around the exemption limit of the interest barrier. In case the debt ratio is reduced, our results present evidence for a proportional increase of firms' tax base. In general, in the short term, no negative investment effects are caused by the TCR. This suggests that a part of the firms is able to substitute equity for debt at low costs or expects to be able to circumvent the regulation. However, investment might also be fixed in the short-run for example due to long-lasting contracts.