Tax benefits of debt
In the context of
equity. Under a majority of taxation systems around the world, and until recently under the United States tax system[citation needed], firms are taxed on their profits and individuals are taxed on their personal income
.
For example, a firm that earns $100 in profits in the United States would have to pay around $30 in taxes. If it then distributes these profits to its owners as
dividends
, then the owners in turn pay taxes on this income, say $20 on the $70 of dividends. The $100 of profits turned into $50 of investor income.
If, instead the firm finances with debt, then, assuming the firm owes $100 of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $30. This implies for $100 of profits before taxes, investors got $70.[1]
This tax-related encouragement of debt financing has not gone uncriticized.capital-structure decisions, potentially reducing the economic instability attributable to excessive debt financing.[2]
See also
- Trade-Off Theory
- Capital structure
- Dividend tax
References
- ^ Graham, John, "How big are the Tax Benefits of Debt" The Journal of Finance, 2000.
- ^ Tul. L. Rev.191 (2010).