Taxes, capital structure and inflation

This dissertation studies the effects of taxes on both capital structure and the costs of inflation. The first chapter presents a theoretical model that examines the combined effects of corporate and personal taxes on the determination of optimal capital structure. There are three differences between this model and other similar models. First, its assumptions on interest deduction is more comparable to what is actually allowed in the real world. Second, while the focus is on firms' financial decisions, investment decisions are not ignored. Third, it is possible to know from this model exactly how the probabilities of tax exhaustion and bankruptcy change with respect to leverage. It is shown that not all firms have interior optimal leverage ratios. In addition, risky firms are more likely to be optimally financed by all equity even when there are no bankruptcy costs or asymmetric information. However, when there are bankruptcy costs, they do not have to be large to have a significant impact on the optimal leverage ratio.; In addition to these results, Chapter 1 also proposes that different firms have different optimal expected corporate marginal tax rates just as they have different optimal leverage ratios. Based on this hypothesis, Chapter 2 examines whether allowing different firms to have different optimal expected corporate marginal tax rates can lead to a stronger empirical relationship between taxes and leverage adjustments. It is shown that allowing this additional flexibility in the empirical model does improve dramatically the explanatory power of taxes on incremental financing decisions.; Chapter 3 examines the effects of nominal tax rules on the costs of low and stable inflation. Nominal tax rules refer to the facts that both depreciation and interest deductions are not indexed to inflation. This chapter calculates the costs of inflation using a perfect foresight general equilibrium model that combines the elements of both Feldstein (1997) and Cooley and Hansen (1989, 1991). It is shown that nominal tax rules can indeed make low and stable inflation very costly to the economy, though the exact magnitude of welfare loss also depends on fiscal policy.