TAX REFORM ACT OF 1986 EFFECT ON CORPORATE CAPITAL STRUCTURE

Whereas the primary function of the federal income tax (FIT) is to provide revenue to finance the operations of government, the FIT has been used to also implement fiscal, economic and social policies. Because tax law is written to achieve non-revenue objectives, and that the relationship between tax law and taxpayer behavior is imperfectly understood, changes in tax law have the potential to create economic consequences for business enterprises that are not anticipated by Congress.; The current study examines the capital structure of firms before and after the Tax Reform Act of 1986 (TRA86) to test empirically the DeAngelo and Masulis (1980) substitution theory. The substitution theory proposes that firms will replace lost investment-related tax shields with debt-related tax shields. In the current study, debt was measured as total interest-bearing debt (TID), as well as using the debt-to-equity (DE) ratio. The empirical analysis included the use of ANOVAs, and t-tests to determine if there was a change. To increase the rigor of the analysis, the data was also detrended to remove the effect of pre-TRA86 trends evident in the growth of debt. Additionally, the analysis controlled for a potential income effect. The income effect was proposed by Dammon and Senbet (1988). The income theory proposes that firms will alter their investment patterns in proportion to the level of investment-related tax shields. Finally, the firms were divided between capital-intensive (CI) and non-capital-intensive firms (NCI). In the dissertation I proposed that the removal of investment-related tax shields should affect CI firms to a higher degree than NCI firms.; TID was examined three ways, gross TID, based on pre-TRA86 trends, and based on pre-TRA86 ratio of net capital expenditures to changes in debt level. All three tests provided evidence of a substitution effect. Additionally, the TID level for CI firms was greater than NCI firms, as expected.; The evidence as to the DE ratio was mixed. Whereas the DE ratio for CI firms increased significantly, the increase was not statistically different than the increase for the NCI firms.