Financial Economics
Ali Nassiri Aghdam; Mahtab Moradzadeh
Abstract
The leverage ratio reflects a company’s relative reliance on capital and debt. Higher leverage ratios, indicating greater dependence on debt relative to equity, ceteris paribus, increase the firm’s financial risks. The present study examined the effect of income tax and deductible financial ...
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The leverage ratio reflects a company’s relative reliance on capital and debt. Higher leverage ratios, indicating greater dependence on debt relative to equity, ceteris paribus, increase the firm’s financial risks. The present study examined the effect of income tax and deductible financial costs on the firm’s leverage ratios. The data was collected from companies listed on the Tehran Stock Exchange during the period 2011–2020. Theoretically, higher effective tax rates and deductible financial costs are expected to lead to higher leverage ratios. These hypotheses were tested using a dynamic panel data model and the generalized least squares (GLS) method. The findings revealed that, after accounting for control variables, the effective income tax rate has no significant impact on the leverage ratio. However, financial costs have a positive and significant relationship with the leverage ratio.IntroductionModern theories of capital structure are rooted in Modigliani and Miller’s (1958) theory of irrelevance of capital structure. According to their theory, under conditions of perfect competition, with no taxes, symmetric information, and the absence of bankruptcy and agency costs, a firm’s value is independent of its financing sources. However, in practice, a firm’s value does depend on its financing sources. In another study, Modigliani and Miller (1963) relaxed the assumption of no taxes and demonstrated that introducing corporate income tax affects the firm’s capital structures. Firms tend to use more debt than equity to optimize financing costs because interest expenses are deductible from taxable income. However, increasing debt also raises the risk of insolvency. This trade-off in leveraging a firm’s capital structure suggests that firms determine an optimal debt-to-equity ratio by balancing the tax savings and bankruptcy costs associated with higher debt levels (Fama & French, 2005). In other words, a higher corporate income tax rate increases the tax shield, incentivizing firms to use more debt. The motivation to take the advantage of tax shield, in turn, increases the risk of bankruptcy (Faccio & Xu, 2015). In Iran, corporate income is subject to a flat tax rate of 25%. Additionally, financial costs, including interest expenses, are treated as deductible, reducing the firm’s tax burdens. Moreover, dividends are tax-exempt due to the absence of personal income tax. These conditions create an incentive for companies to distribute profits and rely more heavily on debt to finance their operations. The present study aimed to test this hypothesis by relying on empirical data.Materials and MethodsThis study used the following regression model to examine the effect of income tax and financial costs on corporate capital structure. The dependent variable is the leverage ratio (lev), calculated as total debt divided by total assets (Chakrabarti & Gruzin, 2019; Rajan & Zingales, 1995). The independent variables are the effective tax rate (ETR) and financial costs (FC). The effective tax rate is determined by dividing tax payments by pre-tax income (Graham, 1996), while financial costs are calculated by dividing interest expenses by total debt (Hossain, 2015). To control for the effects of other factors, the research included several control variables: tangible assets (Gas, 2018; Rajan & Zingales, 1995), growth opportunities (Titman & Wessels, 1988), profitability (Li, 2020), company size (Gas, 2018; Panda & Nanda, 2020), and non-debt tax shields (Chakrabarti & Gruzin, 2019; Gas, 2018; Karadeniz et al., 2009). Before estimating the model using panel data, it was necessary to determine the appropriate data type by using the Limer’s F test. The Hausman test was conducted to decide whether fixed effects (FE) or random effects (RE) is the more suitable estimation method (Gujarati, 2022). Based on the Hausman test results, the fixed effects method was deemed the most appropriate for estimating the model. Moreover, the Wooldridge test and the Wald test were used to evaluate autocorrelation and heteroscedasticity, respectively. Since the p-values in both tests are below 0.05, the null hypothesis was rejected, indicating the presence of autocorrelation and heteroscedasticity in the model. Finally, the generalized least squares (GLS) method was applied to ensure the efficiency of the results (Baltagi, 2008).Results and DiscussionThe GLS method was used to estimate the panel model. As shown in Table 1, the probability of the Wald statistic is less than 0.05, indicating the statistical significance of the regressions (Torres Reyna, 2007). The results of the model estimation revealed that the coefficient for financial costs is significant, and its sign is as expected. Specifically, as financial costs increase, the capital structure becomes more leveraged. This finding aligns with the predictions of static trade-off theory and is consistent with the results of studies such as Akhtar and Massoud (2013). Table 1. Results of Model Estimation Based on Alternative Specifications (Dependent Variable: Leverage Ratio)(5)(4)(3)(2)(1)Variables1.08*(0.57)0.24***(0.095)0.17*(0.095)0.24***(0.095)0.20**(0.096)Financial Cost0.64*(0.34)0.04(0.041)0.05(0.041)0.04(0.04) 0.06(0.040)Effective tax rate -0.17***(0.028)-0.14*** (0.028)-0.18***(0.028)-0.14***(0.028)Tangible assets0.91(0.16)-0.03**(0.015) -0.03**(0.015)-0.02(0.015)Profitability 0.08***(0.02) -0.02***(0.004) -0.03***(0.004)Growth opportunities -0.06***(0.008)-0.05***(0.008)-0.06***(0.008) Size3.52(5.69)0.19(1.81)1.15(1.84) Non-debt tax shield0.59***(0.10) Leverage(-1)164.270.00120.530.00140.500.00121.650.00103.980.00Wald chi2P- value 1.007***(0.057)0.9***(0.057)1.00***(0.056)0.58***(0.012)InterceptP=0.00Arellano-bond test for AR(1) in first differencesP=0.132Arellano-bond test for AR(2) in first differencesP=0.07Hansen test15401540154015401540Observation*P<0.1, **P<0.05,***P<0.01 Standard errors in parenthesesTable 1 presents the model estimation results using the GLS method in Column 1. Columns 2, 3, and 4 display the results of robustness check, with additional control variables included. Column 5 shows the outcomes of the model estimation using the Difference GMM method. A key aspect to note is the consistency of the estimation results. AR1 and AR2, as well as the Hansen test, are related to the GMM estimation in the fifth column.Source: Research findingsThe coefficient for the effective tax rate is not significant, meaning that changes in the effective tax rate do not influence the firm’s decisions regarding their capital structure. Although this finding is unexpected, it is consistent with the results of studies such as Pinto and Silva (2021), Saeedi and Mahmoudi (2011), and Alipour et al. (2015). These researches found the effect of the effective tax rate on the financial leverage ratio to be insignificant. Therefore, the hypothesis that the effective tax rate has a positive effect on financial leverage cannot be confirmed.ConclusionThe estimation results indicated that financial costs have a positive and significant effect on financial leverage. This finding supports the idea that the deductibility of financial costs encourages economic agents to rely more heavily on debt. The results also suggested that the introduction of personal income tax and the taxation of dividends incentivizes companies to reconsider their profit distribution policies and rely more on internal financing rather than debt. This conclusion is consistent with the findings of Haji et al. (2022).
