Company capital structure and tax: a study of mid-sized European companies

This thesis analyses the impact of tax policy on firms' leverage ratios in a balanced panel of 129 medium-sized listed companies from II European countries from 1993 to 2005. A general model of company leverage is applied within which King's tax ratios are used to capture tax policy changes, controlling for non-tax influences suggested by the theory of corporate finance. Various leverage measures are studied to check for the robustness of the estimated model. Total debt is then decomposed into long-term and short-term debt to examine the determinants of different components of debt. The estimation is initially performed within a traditional static framework. The model is estimated using panel data techniques, including the Hausman-Taylor (1981) instrumental variable estimator and the Arellano-Bover (1995) GMM estimator to control for endogeneity. The results suggest that tax policy as measured has a significant but small impact on firms' leverage ratios and the impact is stronger on short-term borrowings than on long-term ones. Non-debt tax shields are a substitute for debt in company activities. With regard to control variables, the empirical findings suggest that non-tax factors affect financing decisions in a way somewhat consistent with the pecking-order theory. There is evidence to support the argument for the differences between the determinants of long-term and short-terin financing decisions. Further research is done by adopting a dynamic adjustment model which allows firms to deviate from their optimal leverage due to random shocks and takes account of adjustment costs incurred when they work back gradually to the optimal level. Arellano-Bond (1991) GMM estimator is applied to obtain consistent estimates. The results substantiate the existence of adjustment costs and corroborate the results from the static model that tax policy measured by King's tax ratios exerts a significant impact on firms' total debt and short-term debt. Finns under the 'Anglo-Saxon' corporate governance systems appear to bear lower adjustment costs and thus have a higher adjustment speed than those under more relation-based systems for all forms of debt. In addition, firms bear lower adjustment costs in adjusting their long-term debt than short-term debt regardless of their corporate governance systems.