The Impact of Thin‐Capitalization Rules on External Debt Usage – A Propensity Score Matching Approach
| DOI | http://doi.org/10.1111/obes.12040 |
| Published date | 01 October 2014 |
| Date | 01 October 2014 |
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©2013 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 76, 5 (2014) 0305–9049
doi: 10.1111/obes.12040
The Impact of Thin-Capitalization Rules on External
Debt Usage –A Propensity Score MatchingApproach*
Georg Wamser
University of T¨ubingen, CESifo and NoCeT, Melanchthonstr. 30, 72074, T¨ubingen, Germany
(e-mail: georg.wamser@uni-tuebingen.de)
Abstract
Thin-capitalization rules (TCRs) aim at limiting the tax advantage of internal debt financing
by restricting the tax deductibility of the corresponding interest expenses. This article
examines how subsidiaries of multinational firms respond to a change in the German
thin-capitalization legislation. The empirical analysis not only demonstrates that the TCR
effectively restricts internal debt financing, it also suggests that firms are able to avoid
taxation of interest by substituting external for internal debt.The empirical approach applies
propensity score matching techniques and exploits the German tax reform 2001 to solve
endogeneity problems.
I. Introduction
Once corporate income taxation is introduced in models of capital structure choice, a firm
may increase its value by using debt instead of equity finance, making use of interest
deductions associated with debt. This essential finding of the corporate finance literature
(for surveys, see Myers, 2001, and Graham, 2003) implies a positive relationship between
debt and corporate taxes, which has been confirmed in a number of empirical studies (see
Feld, Heckemeyer, and Overesch, 2011, for a survey and meta-analysis). A firm’s capital
structure choice, however, involves not only the debt-equity decision. Some companies
also have the choice between internal and external debt finance, which – in the context of
multinational firms – entails complex issues of international tax planning. For example,
the use of cross-border internal loans allows multinational firms to shift profits from high-
to low-tax countries and to minimize the overall tax burden as the value of tax deduction
associated with interest expenses of the borrowing corporate entity (located in the high-tax
country) exceeds the tax cost of interest income of the lending corporate entity (located in
the low-tax country).
JEL Classification numbers: G32, H25.
*I am grateful to the Deutsche Bundesbank for granting access to the MiDidatabase. I thank Chang Woon Nam,
F´ed´eric Holm-Hadulla, Valeria Merlo, two anonymous referees as well as Beata Javorcik (the editor) for helpful
comments and discussions. All errors, omissions, and conclusions remain the sole responsibility of the author.
Thin-capitalization rules and external debt usage 765
Since profit shifting by multinational firms implies that high-tax countries are con-
strained in their abilities to raise corporate tax revenue, many governments have
focused attention on anti-tax-avoidancemeasures such as thin-capitalization r ules (TCRs).1
These rules restrict the deductibility of interest expenses to limit the tax advantage of inter-
nal borrowing. Some recent studies suggest that TCRs are effective and reduce
internal debt financing (Weichenrieder and Windischbauer, 2008; Overesch and Wamser,
2010; Buettner et al., 2012). Hence, according to this literature, it seems that TCRs work
as they should. But even if TCRs remove tax incentives associated with internal debt, it
is not clear whether extra tax revenue is raised. In fact, apart from investment responses,
any such conclusion ignores that firms facing stricter TCRs may avoid taxation of interest
by substituting external for internal debt: The reason is that external debt is usually not
subject to TCRs and interest payments for external debt remain tax deductible.
Whether a country’s cor porate tax base is broadened by the introduction or tightening of
a TCR basicallydepends on the responses of firms with respect to investment and financing.
In this article, we focus on the latter by examining the responsiveness of subsidiaries to
TCR treatment regarding their external debt financing. In case of treatment, subsidiaries
have to consider – when deciding upon their capital structures – that the interest costs of
internal debt are no longer tax deductible, while interest costs associated with external debt
remain deductible and untaxed. We argue that this gives rise to an incentive to substitute
external for internal debt: by using more external debt, firms can avoid restrictions on
internal debt and still benefit from the tax advantage of debt relative to equity. As internal
and external debt may be used for different reasons, the extent of substitution depends on
how similar the (tax and non-tax) costs and benefits of internal and external debt are.
To find out about the extent of substitution in such a context is challenging, because
firms simultaneously decide on both internal and external debt usage. Therefore, to obtain
reliable estimates, this study makes use of a more sophisticated identification strategy
that exploits a reform of the German TCR and adopts a counterfactual perspective by
applying propensity score matching methods. The analysis is based on a subsidiary-level
data set on foreign direct investments in Germany provided by Deutsche Bundesbank (the
German Central Bank). The findings support the hypothesis that subsidiaries of foreign
multinationals partially substitute external for internal borrowing if they are treated by the
TCR. The estimations implythat treated subsidiaries increase their exter nal-debt-to-capital
ratio by approximately 5.1 percentage points compared to the counterfactual outcome.
With regard to the external debt level, the estimated average treatment effect on the treated
(ATT) suggests that treated firms expand their exter nal debt usage by more than 18%. If
tax policy aims at shielding tax revenue, these findings imply a limited effectiveness of
TCRs, applying to internal debt only.
The study proceeds as follows. Section II providesinstitutional details about the German
thin-capitalization legislation. We discuss tax incentives on debt finance and the effects of
a TCR in Section III. The empirical investigation approach is developed in Section IV.
Section V describes the data. Section VI reports and interprets the results. Section VII
concludes the article.
1From 1996 to 2005, the number of EU member countries relying on a TCR increased from 9 to 18.
©2013 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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