The Effect of Corporate Tax Rates on Financial Leverage: Evidence From China’s 2015 Deleveraging Program

With a surge in debt due to a fiscal stimulus after 2008, the Chinese government rolled out a “deleveraging” program in 2015, which, through tightening monetary policies, restricting credit flows, and regulating shadow banks, significantly increased firms’ cost of debt and the incentive to deleverage. We find that high-tax-rate firms reduce leverage to a lesser extent than low-tax-rate firms after the initiation of the deleveraging program. This effect is stronger for nonstate-owned firms and firms with fewer nondebt tax shields. More importantly, by retaining more debt, high-tax-rate firms reduce dividends, switch to equity financing to a lesser extent, and cut fewer investments in fixed assets, R&D and human capital. We conclude that taxes constitute an important factor in shaping the microeconomic consequences of a credit crunch and that economic incentives and property rights interact to affect capital structure.