effects of tax integration and capital gains tax on corporate leverage · 2019-04-11 · tax...

TAX INTEGRATION AND CAPITAL GAINS TAX

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EFFECTS OF TAXINTEGRATION ANDCAPITAL GAINS TAX ONCORPORATE LEVERAGECRAIG T. SCHULMAN, * DEBORAH W.THOMAS, ** KEITH F. SELLERS, **

& DUANE B. KENNEDY ***

ABSTRACT - This study investigateswhether the adoption of integration inNew Zealand and Canada had asignificant impact on corporate financingdecisions in those countries. BecauseCanada instituted a capital gains tax onthe sale of stock concurrent with theadoption of integration, firms withinthe Canadian samples believed to beaffected by one of these tax changesand not the other are identified. Usingregression analysis, we substantiate thattax integration significantly reducedcorporate debt-to-equity ratios in NewZealand and Canada, supportingtheoretical arguments that the imputa-tion credit method of integration canreduce corporate financial leverage.However, this favorable impact is verysensitive to changes in tax rates,particularly taxes on gains realizedthrough stock appreciation.

Corporate tax integration, designed toeliminate or reduce double taxation ofcorporate dividends, has been adoptedby most industrialized nations (Avi-Yonah, 1990). Tax policymakers in theUnited States, however, continue todebate the benefits of integration. In1992, three major U.S. studies onintegration—by the Department ofTreasury (U.S. Treasury, 1992), theAmerican Law Institute (ALI, 1992), andthe American Institute of CertifiedPublic Accountants (AICPA, 1992)—reflected renewed interest in the topic.All three groups advocate adoptionof integration in the United States,citing the bias in favor of debt financ-ing, which increases corporate leverage,as a problem under the current taxsystem (U.S. Treasury, 1992, A.3; ALI,1992, p. 2–3; AICPA, 1992, p. 3).

This study investigates the effect ofintegration on corporate leverage byfocusing on two countries which haveadopted integration, Canada and NewZealand. In New Zealand, integrationwas adopted without any change in the

*Department of Economics, University of Arkansas, Fayetteville,

AR 72701, and Applied Economics Division, U.S. International

Trade Commission, Washington, D.C. 20436.**Department of Accounting, University of Arkansas,

Fayetteville, AR 72701.***School of Accountancy, University of Waterloo, Waterloo,

Ontario, Canada N2L 3G1.

INTRODUCTION

NATIONAL TAX JOURNAL VOL. XLIX NO. 1

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taxation of capital gains. In Canada, acapital gains tax on realized stock gainswas adopted at the same time integra-tion was implemented. Evaluation ofthe experiences of these countriesshould provide evidence on the relativeimpact of tax integration and capitalgains taxes on corporate financingdecisions.1

INTEGRATION IN NEW ZEALAND ANDCANADA

The Imputation Credit Method ofIntegration

Both countries under investigationadopted the most popular integrationmethod, the imputation (or shareholder)credit method, which provides relieffrom double taxation at the shareholderlevel. While variations exist amongcountries, the basic attributes of thecredit method are the same. Corpora-tions continue to pay corporate incometaxes, recording the amount of tax paid.When dividends are distributed,shareholders include in taxable incomethe amount of the dividend, “grossed-up” for the corporate tax paid. Aftercomputing their individual tax, theshareholders receive a credit in theamount of the tax paid at the corporatelevel.2

New Zealand

In his Statement on Taxation and BenefitReform 1985, New Zealand’s Minister ofFinance announced the intention of thegovernment to adopt corporate taxintegration. Reasons cited for elimina-tion of the double taxation of dividendsincluded the need to remove the bias toretain earnings rather than distributedividends and the bias for debt financ-ing over equity capital, leading toheavier indebtedness.

After study by the government and thelegislature, an imputation credit systemwas placed in operation on April 1,1988, retroactive for the entire year.The tax reform package adopted in NewZealand also reduced tax rates.3 Incontrast to the United States andCanada, New Zealand does not taxgains realized on the sale of corporatestock held for investment.

Canada

Canada’s consideration of integrationbegan in 1962, when a Royal Commis-sion on Taxation (the Carter Commis-sion) was appointed. The report laterissued by this Commission advocatedfull integration. Canada’s adoption of apartial imputation credit system becameeffective in January 1972.4 Along withthe implementation of integration, a taxon the sale of stock held for investmentwas introduced for the first time.5 One-half of realized capital gains becametaxed at ordinary income tax rates.Thus, gains arising from stock apprecia-tion still received a tax preference, but asignificantly smaller one than before.Like New Zealand, Canada reduced bothcorporate and individual tax rates aspart of its tax reform.

RESEARCH ON THE IMPACT OF TAXESON CAPITAL STRUCTURE

Extensive research has attempted tomeasure the effect of taxes on capitalstructure. Numerous studies, includingTitman and Wessels (1988), Fisher,Heinkel, and Zechner (1989), Long andMalitz (1985), and Bradley, Jarrell, andKim (1984), failed to detect anyassociation between taxes and capitalstructure. On the other hand, DeAngeloand Masulis (1980), Pozdena (1987),MacKie-Mason (1990), Dhaliwal,Trezevant, and Wang (1992), and Givolyet al. (1992) found evidence that taxes


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1

2

1

2

can affect capital structure. Thedifference in findings is likely due tothe confounding effects of nontaxdeterminants of capital structure, as wellas firm-specific differences in tax position.

Nontax factors that are believed toaffect capital structure range fromcorporate financial distress to manage-ment signaling. For example, Marsh(1982) determined that firms appearto have a “target” capital structure andthat firm size, risk of bankruptcy, andasset composition were all associatedwith this target. Jensen (1986)proposes that certain agency costs arealso determinants of capital structure.He argues that debt can reduce agencycosts associated with shareholder andmanagement conflict over dividendpolicies. Dividends are discretionary,and management resists their paymentsince they reduce the resources, andthus the power, of management.Under Jensen’s “control hypothesis,”debt acts as a form of guaranteeddividend, ensuring payouts to investorsand reducing the amount of discretion-ary cash flows available to management.

The marginal tax rate of a firm may alsolimit the impact of taxes on its capitalstructure. Interest payments representonly one of a variety of available taxshields. If a firm uses sufficient taxshields from depreciation (net operatingloss carryforwards, etc.) to reducetaxable income to zero, debt may yieldno additional tax benefit, and capitalstructure decisions will be based onnontax considerations.

RESEARCH ON THE EFFECTS OF TAXINTEGRATION

Corporate tax integration has beenadopted by many countries in pursuit ofa variety of economic objectives. Priorempirical research on integration has

focused primarily on the impact ofintegration on capital markets anddividend policy.

Gourevitch (1977) reviewed the objec-tives of European countries in adoptingan integrated tax system. In 1965,France adopted an imputation creditmethod of integration to stimulate thedepressed French stock market. Simi-larly, Germany introduced a split-ratesystem in 1953 with the objective ofreviving Germany’s postwar stockmarket. In 1976, Germany alsoimplemented an imputation credit toreduce the tax biases in favor of debtover equity and in favor of thenoncorporate over the corporate formof business organization. The UnitedKingdom adopted its version of ashareholder credit system in 1972 toremove discrimination between retainedand distributed profits and to promotenew equity capital. Reviewing theeconomic evidence of the effects ofintegration in these countries,Gourevitch reported that payment ofdividends did not increase in eitherFrance or the United Kingdom. In theUnited Kingdom, however, thegovernment’s anti-inflationary policies,introduced simultaneously with integra-tion, probably negated any benefitsarising from integration.6 In Germany,total dividends did appear to increasesignificantly after the adoption ofintegration. This increase may also havebeen influenced by the tremendousincrease in earnings experienced byGerman firms after World War II. Actualfinancing behavior did not appear tochange since Germany, like France,experienced no increase in the propor-tion of corporate capital financed withnew equity.

Amoako-Adu (1983) and Amoako-Adu,Rashid, and Stebbins (1992) investigatedthe effects of Canadian tax reform,


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3

which included both integration and anew tax on capital gains, on stockprices. Results indicated that highdividend stocks increased significantly invalue, while no significant change wasfound in low dividend stocks. Withintegration, the after-tax value of adividend to an individual shareholderincreases by 1/(1 – TPD), where TPD is theindividual tax rate on ordinary income.Thus, high dividend corporations shouldbe able to reduce dividends whilemaintaining or even increasing returnsto shareholders, lowering the cost ofequity financing. On the other hand,low dividend firms obtain little directbenefit from integration, since theyprovide a return to shareholdersthrough stock appreciation. The resultsof Amoako-Adu (1983) and Amoako-Adu, Rashid, and Stebbins (1992)support the hypothesis that the effectsof integration and capital gains taxes oncorporate capital structure depend onthe relative return provided to share-holders from dividends and stockappreciation. However, the actualimpact on corporate financing decisionswas not addressed in that study.

Poterba and Summers (1985) investi-gated the effects of the UnitedKingdom’s changes in the taxation ofdividends on security returns, dividendpayout rates, and corporate investment.They determined that integration in theUnited Kingdom significantly reducedthe premium required to induceinvestors to receive returns in dividendform. While the study did not addressthe issue of capital structure, thefindings indicate that the cost of equitycapital should decrease as the requiredpretax dividend yield drops.

Using econometric models, researcherssuch as Feldstein and Frisch (1977) andGravelle (1992) have attempted to

project the impact of proposed integra-tion alternatives in the United States.Nadeau and Strauss (1993) simulatedthe effects of a revenue-neutral plan ofintegration on the U.S. economy,offsetting the estimated revenue losscaused by a shareholder credit withcorporate tax increases. The simulationmodel was constructed from estimatesof the responsiveness of debt-to-equityratios, investment, and dividend payoutto other variables including tax rates oncorporations, capital gains rates, interestincome, and dividend income. Thesimulations indicate that partial integra-tion would lead to an economywidedecrease in debt-to-equity ratiosapproximately proportional to thedegree to which individual taxes areoffset by integration.

Boadway and Bruce (1992) analyze theeffects of tax integration on small openeconomies, concluding that wheninvestors have a choice between debtinstruments, existing equity (retainedearnings), and new equity issues, “thedividend tax credit is likely to removenon-neutralities of the tax system withrespect to the firm’s financial decisions”(p. 60). They found that in a closedeconomy, a shareholder credit wouldachieve the economic goals espoused byproponents of integration. However,they argue that in a small openeconomy, “[a]lthough the dividend taxcredit does achieve some neutralities inthe income tax system regarding thefinancial structure and the organizationof the firm, it does not achieve thesaving and investment allocation thatcorresponds to a perfectly integratedincome tax” (p. 62).7 In a similar vein ofresearch, Grubert and Mutti (1994)simulated the effects of integration inan international setting, concluding thatthe type of integration method has aneffect on the direction of internationalcapital flows.


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Prior empirical research on the effects oftax integration is neither extensive norconclusive. While integrated systemshave generally been adopted in pursuitof specific economic objectives, theability of integration to achieve theseobjectives remains unresolved.

THEORETICAL RELATIONSHIP BETWEENTAXES AND CORPORATE CAPITALSTRUCTURE

One of the primary reasons cited foradopting integration is to reduce theeffect of taxes on corporate capitalstructure. These tax effects can beillustrated with a model in which thecost of capital to the corporation isrelated to the return on the investmentof the individual. It is assumed thatthere exists an equilibrium mix of debtand equity for firms and for investors. Ifthe incremental cost of equity exceedsthat of debt, a corporation will obtainits next dollar of external capital byissuing debt and will continue to do sountil its cost of new debt equals that ofequity. Similarly, if the (risk adjusted)return on equity is greater than that ofdebt, investors will prefer equityinvestment over debt investment untilthe return on debt is equated with thereturn on equity. Rationally, firms willtake advantage of any disequilibrium tominimize their cost of capital, whileinvestors will do the same to maximizetheir return. With these basic premises,the effects of taxes on corporate capitalstructure can be illustrated.

From the standpoint of the corporation,the equilibrium debt to equity positioncan be expressed as

CD Ri (1 – Tc) = CE

where

CD = the cost for debt financing forthe firm,

CE = the cost of equity financing forthe firm,

Ri = the interest rate for debtfinancing, and

Tc = the firm’s marginal tax rate.

This equation demonstrates thepopularly cited “tax bias” arising fromthe disparate tax treatment of interestand dividend payments. As thecorporate tax rate increases, the costof debt financing is reduced, (∂CD/∂Tc) <0, and firms will favor debt overequity.

The impact of personal taxes on a firm’sfinancing decision is less direct. Inves-tors in corporate equity receive returnsin the form of dividends, stock apprecia-tion, or a combination of both, whileinvestors in corporate debt receivereturns simply in the form of interest.The equilibrium position from theinvestor’s viewpoint occurs when thereturn on debt equals the return onequity (assuming appropriate riskadjustments), which can be expressed asfollows:

Ri(1 – Ti) = Rd(1 – Td) + Rcg(1 – Tcg)

where the left-hand side of equation 2is the after-tax return on corporate debt,the right-hand side is the after-taxreturn on corporate equity, and

Ri = the expected return in the formof interest,

Rd = the expected return in the formof dividends,

1

2

=


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Rcg= the present value of expectedreturns in the form of capitalgains; the present value reflectsthe ability of the shareholder todefer the gain, and thus the taxon it, by holding the stock,

Ti = the investor’s marginal tax rate oninterest payments,

Td = the investor’s marginal tax rateon dividends, and

Tcg = the investor’s marginal tax rateon capital gains.

The returns Ri, Rd, and Rcg are assumedto be non-negative. The marginal taxrates for investors (Ti, Td, and Tcg) willvary among taxpayers and, dependingupon the type of investor, will rangefrom the maximum statutory rate tozero. However, the analysis whichfollows requires only that these rates benon-negative and that a substantialportion of investment capital originatefrom investors who face positivemarginal tax rates.

Because the interest paid by thecorporation can be equated with theinterest received by the investor,equations 1 and 2 can be combined toexpress the cost of debt as follows:

If the tax rate on interest and dividendsis the same (Ti = Td = Tp), as it is for anindividual investor in a classical taxsystem, equation 4 becomes

and the impact of the individual taxrates on corporate capital structure canmore easily be observed. Beginningfrom an initial equilibrium, if theindividual tax rate increases, then thecost of debt increases relative to equity,(∂CD/∂Tp) > 0, such that thecorporation’s preference for financingnew capital will be shifted away from anindifference between debt and equitytoward new equity.

Equation 4 also illustrates the effects ofa tax on capital gains on the cost ofdebt relative to equity capital for thecorporation. As the capital gain tax rateincreases, the cost of debt relative to thecost of equity decreases, (∂CD/∂Tcg) < 0,such that new debt issuances becomemore attractive.

With the adoption of the shareholdercredit method of integration, theimportance of taxes on capital structurechanges. The shift in importance can beseen by comparing equation 4 (repre-senting the classical tax system) withequation 3 (representing an integratedsystem). With a shareholder creditmethod of integration, the taxes ondividends are reduced, such that Td < Ti.After integration, changes in thepersonal tax rates on dividends andinterest will have opposite effects oncorporate financing. As the tax rate oninterest increases, the cost of debtincreases, (∂CD/∂Ti) > 0, making equitycapital more attractive. As the tax rateon dividends increases, the cost of debtrelative to equity decreases, (∂CD/∂Td) <0, such that corporations will increasedebt to return to equilibrium. Under thecredit method of integration, themarginal tax rate on dividends remainstied to the tax rate on interest (Td =λTi). If this link remains fixed (λ isconstant and less than one), increases inthe personal tax rate after integrationcontinue to have the same directional

3

4

CD = (1 – Tc) Rd

(1 – Td)

(1 – Ti)+ Rcg

(1 – Tcg)

(1 – Ti)( )

CD = (1 – Tc) Rd+ Rcg

(1 – Tcg)

(1 – Tp)( )


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effect on the cost of debt, but the effectis magnified (the effect of changes in Ti

more than dominates the effect ofchanges in Td).

8 However, the initialmove to an integrated system should beaccompanied by a decrease in debtfinancing relative to equity sinceintegration implies a decrease in the taxrate on dividends from Td = Ti to Td < Ti.

It is also important to note that theintroduction of a separate tax rate fordividends changes the relationship of allof the taxes discussed above withrespect to their effect on corporatefinancing. While the directional effectsof the corporate tax rate, the capitalgains tax rate, and the personal tax rateremain the same, the magnitude ofthese effects may not be the samebefore and after integration.

RESEARCH DESIGN

To determine the effects of integrationon corporate capital structure, this studyinvestigates the reaction of firms to theimplementation of an imputation creditin New Zealand and Canada. If, astheorized, the adoption of integration iseffective in reducing the bias in favor ofdebt financing, a reduction in the debt-to-equity ratios of firms in thesecountries should be observed.

In New Zealand, integration was theonly significant tax change which shouldaffect corporate financing decisions. InCanada, however, a capital gains tax onthe sale of corporate stock was imple-mented along with integration. Whileintegration was designed to reducedebt-to-equity ratios, an increase in thecapital gains tax should have theopposite effect. To the extent that thereturn on equity is realized throughappreciation of share value, a tax on thesale of stock should reduce the value ofshares, making debt more attractive.

The cumulative result on the capitalstructure of Canadian firms dependsupon whether corporate financingdecisions are more sensitive to the newtax relief for dividends or the penalty ofthe capital gains tax. As discussedbelow, the effects of these two taxesare isolated by categorizing firms morelikely to be affected by one tax changethan the other.

VARIABLE DESCRIPTION

To test the reaction of firms to taxintegration and, in Canada, the intro-duction of a tax on capital gains, apooled cross-sectional time-seriesregression model is formulated in whichthe dependent variable, corporateleverage, is regressed on several taxvariables, firm-specific variables, andeconomic variables believed to impactcapital structure.

Dependent Variable

Debt-to-Equity Ratios

To measure corporate leverage (LEV ) ,values for total debt and total equity arecalculated for each corporation for eachyear examined. In this study, total debtis measured as the total book value ofassets less the book value of commonand preferred equity. Total equity, asused in the debt-to-equity ratio, ismeasured as the total book value ofcommon and preferred equity. Al-though the market values of debt andstock are important in the securitymarkets’ evaluation of a firm’s degree offinancial leverage, for this study, bookvalues offer better measures for severalreasons.

The use of book values for debt raisesfew concerns. Bowman (1980) andMulford (1985) determined that theaccounting measures of debt are nearly


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perfectly correlated with marketmeasures and that leverage ratios usingthe debt book values are equally usefulin the evaluation of capital structure.

The book value of equity, as definedabove, is affected only by corporatefinancing decisions. Studies such asAmoako-Adu, Rashid, and Stebbins(1992) and Amoako-Adu (1983) havedetermined that Canadian equitysecurities experienced significantreactions to the 1972 tax integrationlegislation. Thus, the use of marketvalues in the denominator of the ratiowould impound price variances arisingfrom the tax legislation being studied, aswell as other extraneous economicevents affecting security values. There-fore, the book value of equity shouldprovide a better measure of the internaldecisions of the firm.

Financial statement information for NewZealand corporations was obtained fromthe Compustat Global Vantage data-base. These tapes include data from1982 through 1991, allowing severalyears to be observed both before andafter integration. The methodology,described below, requires that data beavailable for each company in each yearexamined, so only those firms present inthe database for all years are included.The resulting New Zealand sampleconsisted of 12 firms with ten yearlyobservations (1982–91) on each firm, or120 total observations used for estimation.9

The Canadian sample consisted of 184firms with ten yearly observations(1968–77) on each firm.10 For firms withvery small or very large debt-to-equityratios, a small fluctuation in either debtor equity could result in a dramaticchange in the ratio, confounding theresults of the test. Therefore, any firmwhich had a debt/equity of less than0.05 (debt close to zero relative to

equity) or greater than 20 (equity closeto zero relative to debt) in any year wasconsidered an outlier.11 Using theseguidelines, a total of 22 Canadian firmswere dropped from the evaluation.12

This resulted in a sample of 162 firms,or 1,620 total observations, to be usedfor estimation.

Tax Variables

Tax Integration (TINT)

The variable of primary interest is thepresence of an integrated tax system,which is indicated by a dummy variable.In reality, the dummy variable shouldcapture the effect of all tax reformchanges enacted simultaneously withintegration. Further testing, explainedbelow, isolates the effects of integrationand capital gains taxes in Canada.

Tax Rates (CTAX)

The second tax variable reflects changesin income tax rates. During the yearssurrounding the adoption of integration,each country significantly reducedcorporate and individual income taxrates. Because both tax rates theoreti-cally impact capital structure, ideally,both individual and corporate rateswould be included in the model toaccount for these effects. This isespecially true since theory wouldpredict that they have opposite effectson corporate leverage. However,individual and corporate income taxrates exhibit a high empirical correlationover the sample period under study, andthe presence of both variables wouldintroduce multicollinearity into themodel.13 Thus, for this study, tax rate(CTAX ) is defined as the maximumfederal corporate tax rate, expressed asa percentage. Since CTAX proxies forboth individual and corporate tax rates,the sign of its effect on corporate


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leverage is ambiguous. To the extentthat the effect of corporate (personal)rates dominate those of personal(corporate) rates, CTAX will have apositive (negative) effect. If the effectsof corporate and personal rates offsetone another, then CTAX should have noeffect on corporate leverage.

Tax Rate–Tax Integration Interaction

(CTAX*TINT)

The final tax variable reflects changes inthe effect of income tax rates onleverage due to integration. To accountfor the theoretical effect of integrationon the sensitivity of corporate financingdecisions to changes in tax rates, aninteraction effect between the CTAXand TINT variables is added to themodel. As with the CTAX variable, thesign of this interaction term is ambiguousbecause the effect of both corporate andpersonal rates could be affected byintegration. A simple example willsuffice to illustrate this point.

Suppose the “true” model of corporateleverage is as follows:

+ other variables

where LEV, CTAX, and TINT are asdefined above and PTAX representspersonal income tax rates. As specified,equation 5 allows for the possibility thatthe effects of both CTAX and PTAX aredifferent before and after integration.If, as in the present sample, CTAX andPTAX exhibit a high empirical correla-tion, then PTAX ≈ aCTAX. Uponsubstitution, equation 5 can then bewritten as

LEV = b0 + (b1 + ab2) CTAX + (b3 + ab4)

CTAX*TINT + other variables

= b0 + b1* CTAX + b3* CTAX*TINT

+ other variables

The measured effect of CTAX oncorporate leverage, b1

* , may be positive,negative, or zero depending on therelative magnitudes and signs of b1 andab2, and similarly for b3

* , the measuredeffect of the interaction between thetax rate and integration. Note thatwithin this framework, the individualeffects of personal and corporate taxrates cannot be separated. Further,this does not present a problem sincethe primary variable of interest inthe current study is TINT and taxrates enter the model as a controlvariable.

Firm-Specific Variables

Two types of variables specific for eachfirm are defined, independent variablesand sorting variables. The independentvariables, size and debt securability, areincluded in the model as attributes offirms which could affect capital struc-ture. The sorting variables, as describedbelow, are used to identify the types offirms which should react differently tothe tax changes enacted during the timeperiod under investigation.

Independent Variable: Size (SIZE)

Due to economies of scale, the cost ofrestructuring capital is believed to beless restrictive to larger firms. Priorresearch has determined size to be asignificant determinant of capital

5

6

LEV = b0 + b1 CTAX + b2 PTAX

+ b3 CTAX*TINT + b4 PTAX*TINT


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structure (Givoly et al. 1992). A sizevariable, computed as the natural log ofthe total assets of each firm, is incorpo-rated into the model.

Independent Variable: Debt Securability

(DSEC)

The second firm-specific variableincluded in the model is the debtsecurability of the firm. Several studies,including Myers (1977) and Givoly et al.(1992), address the concept ofcollateralization and the ability of a firmto obtain debt financing. Collateraldecreases the risk to debt holders,resulting in a lower risk premium andcost of debt capital. A debt securabilityvariable, measured as the ratio of fixedassets to total assets, indicates theability of the firm to collateralize loanswith tangible assets.

Sorting Variable: Tax Shields (NOL)

As the probability of incurring a netoperating loss (NOL) increases, themarginal tax rate for a firm decreases(Shevlin, 1990; Scholes and Wolfson,1992). For any firm, the expectedimpact of a tax change is a function ofthat firm’s marginal tax rate and, thus,NOL status. Empirically, two relation-ships between NOLs and taxes havebeen demonstrated that impact thisstudy. First, Auerbach and Poterba(1986) document a strong relationshipbetween NOL carryforwards and theprobability of having a lower marginaltax rate in the future. They indicate thatfirms with net operating losses may notrespond to tax changes since these firmsare effectively tax exempt, at least in theshort run (their marginal tax rate is low).Second, MacKie-Mason (1990) foundthat as the probability of incurring anNOL increases, the effects of taxchanges decrease. Both countries underinvestigation allow carryover of NOL

deductions. A firm that has experienceda loss during the time period examinedin the study is defined to be an NOLfirm and is treated as a separate group,or portfolio. This group of firms is lesslikely to be affected by integration.

Sorting Variables: High Dividend Yield or High

Growth Yield

Taxes which affect corporate capitalstructure include both the rates ondividends and on capital gains. NewZealand adopted only integration,reducing the tax rate on dividendswithout changing the taxation of capitalgains. In Canada, both the rates ondividends and capital gains were alteredduring the period under investigation,requiring two additional variables in themodel for Canadian firms.

As discussed above, an increase in thetax on capital gains should make debtthe more attractive source of corporatefinancing, while the implementation ofintegration should have the oppositeeffect. However, the magnitude ofthese effects should differ dependingupon the type of return to the investor.Firms most likely to benefit fromintegration are those that pay highdividends (Amoako-Adu, 1983;Amoako-Adu, Rashid, and Stebbins,1992). Companies most likely to reactto taxes on capital gains are growthfirms who offer significant returns toshareholders in the form of stockappreciation. Hereafter, these twogroups are referred to as high dividendfirms and high growth firms. To isolatethe relative effects of integration andcapital gains taxes in Canada, a variableidentifying high dividend firms and oneidentifying high growth firms areincluded as sorting variables to classifyfirms into high dividend–low growthand high growth–low dividend groups.


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Firms are classified into these twogroups using the following procedure.The mean return from dividends andgrowth from retained earnings (relativeto total equity) over the preintegrationperiod were calculated for each firm.14

Firms were then rank ordered accordingto each measure. A firm was classifiedas a high growth firm if it (1) was not anNOL firm, (2) had a retained earningsgrowth rank above the median growthrank, and (3) had a return on dividendsranking below the median dividendsrank. Similarly, a firm was classified as ahigh dividend firm if it (1) was not anNOL firm, (2) had a return on dividendsranking above the median dividendsrank, and (3) had a retained earningsgrowth rank below the median earningsrank. The remaining firms consisted ofall NOL firms, as well as firms thatgranted relatively equal returns fromdividends and stock appreciation. Meanvalues for the return from dividends andgrowth from retained earnings over thepreintegration period for the resultingfour portfolio subsamples are providedin Table 1.

Economic Variables

Corporate leverage may also besensitive to economic factors whichcould confound the effects of taxchanges. During the years investigatedin this paper, both countries experiencednotable economic changes. To determinethe effects of these changes on corpo-rate capital structure, several indicatorsof economic activity were examined.The economic variables for each countrywere derived from the InternationalMonetary Fund’s International FinancialStatistics Yearbook (IMF, 1991).

Unexpected Inflation (INFL)

repayment of the debt can be madewith currency of lesser value. Obviously,lenders are equally aware of thisphenomenon and incorporate expectedinflation into the required rate of returnon debt. If projections of futureinflation change, the required returnand thus cost of debt and equityfinancing should also change to reflectthe new projections. Thus, an annualmeasure of unexpected inflation isincluded to detect the effects ofinflation on capital structure decisions.This measure is derived from a rationalexpectations model of the aggregateprice level by performing a regressionwhere the dependent variable is theprice level and the independent vari-ables are: the lagged value of the pricelevel, an index of wage rates, the laggedvalue of an index of import prices, and atime trend.15 The variable INFL is thendefined as the difference in the ob-served rate of inflation (the percentagechange in the actual price level) and therate of inflation as predicted by thismodel.

TABLE 1MEAN VALUES OF PORTFOLIO-DEFINING VARIABLES

OVER PREINTEGRATION PERIOD: CANADA

GrowthReturn fromfrom Retained

Group Dividends Earnings N*T

NOL firms 0.023 0.094 188(0.026) (0.227)

High growth firms 0.012 0.328 92(0.017) (0.221)

High dividend firms 0.072 0.112 104(0.077) (0.064)

All other firms 0.060 0.218 264(0.047) (0.133)

Notes: Standard errors are in parentheses.N*T is the total number of observations. N is thenumber of firms; 47, 23, 26, and 66 in the NOL, highgrowth, high dividend, and all other groups,respectively. T is the number of years in thepreintegration period, 1968–71.

Generally, debt financing becomes moreattractive as inflation increases because


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Stock Market Index (STK)

Stock market values have been deter-mined to affect corporate financingdecisions. When stock prices rise, thecost of issuing equity decreases andcorporations favor equity financing(Marsh, 1982; Myers and Majluf, 1984).When stock values are depressed,corporations prefer debt financing andwill even finance stock repurchases withnew debt issues. Thus, a measure ofchanges in stock prices, defined as thechange in the level of the stock marketindex reported by the InternationalMonetary Fund, was added to the model.

DESCRIPTIVE STATISTICS

Table 2 presents the mean values of thedebt-to-equity ratios and the indepen-dent variables over the preintegrationand postintegration periods, along withtests of whether the means are equalacross the two periods. For Canada,additional statistics are presented for thefour subsets, or portfolios, of firmsdefined as NOL firms, high growthfirms, high dividend firms, and allothers. Note that for the New Zealandsample, overall mean debt-to-equityratios fell from 2.69 to 1.40 betweenthe preintegration and postintegrationperiods; a 48 percent decrease. How-ever, the overall mean debt-to-equityratios for the Canadian sample in-creased by 22 percent. As will bediscussed shortly, after controlling forthe effects of the independent variablesdescribed above, a significant portion ofthe decrease in New Zealand debt-to-equity ratios can be attributed to taxintegration, while the increase in meandebt-to-equity ratios in Canada wouldhave been larger in the absence ofintegration.

STK and INFL variables. In New Zealand,the stock price index exhibited a steadyincrease from a level of 45 in 1982 to198 in 1987 before experiencingsubstantial annual decreases to end at104 in 1991. New Zealand alsoexperienced high and volatile rates ofinflation with the unexpected portion ofinflation averaging –1.27 percent beforeintegration (on average, inflation was1.27 percent lower than expected) and+5.42 percent over the postintegrationperiod. By contrast, Canada experi-enced very little annual unexpectedinflation during the period underinvestigation. However, the summarystatistics for changes in Canadian stockprices mask significant annual fluctua-tions in the index, from a 16 percentdecrease in 1972 to a 17 percentincrease in 1974.

METHODOLOGY

To investigate the effects of tax integra-tion (and the introduction of capitalgains taxes in Canada) on firms’ debt-equity decisions, pooled time-seriescross-sectional regression techniques areemployed. While changes in a firm’scapital structure take place over time inresponse to general macroeconomicvariables, individual firm characteristicsalso influence financing decisions.Pooled time-series cross-sectionalregression analysis, which will controlfor the independence of each firm’sdecisions and situation, is the appropri-ate tool for the purposes of this invest-igation. As Hsiao (1985, pp.122–3) notes

[P]anel data allow economists and othersocial scientists to analyze, in depth,complex economic and related issueswhich could not be treated with equalrigor using time-series or cross-sectionaldata alone. Like cross-sectional data,panel data describes each of a numberof individuals. Like time-series data, itdescribes changes through time. By

Note the relative volatility of the twocountry’s economies as captured by the


43

blending characteristics of both cross-sectional and time-series data, morereliable research methods can be used inorder to investigate phenomena thatotherwise could not have been dealtwith.

To capture the advantages afforded bypooled data, it is necessary to beginwith a “least restricted” model, namely,time-series regression on individualfirms, and to “test down” to the morerestricted pooled model.16

LEVit = αi + β1iTINTt + β2iCTAXt

+ β3iCTAXt*TINTt + β4iSIZEit

+ β5iD SECit + β6iSTKt + β7iINFLt + εit

where I = 1,. . .,12 indexes firms and t =1982,. . .,1991 indexes years. Notethat, for a given time period, the TINT,CTAX, STK, and INFL variables areidentical for all firms.17 Firms were thendivided into two portfolios based ontheir NOL status. As described above, a

TABLE 2MEAN LEVELS OF VARIABLES OVER PREINTEGRATION AND POSTINTEGRATION PERIODS

New Zealand

Group Period N*T LEV SIZE DSEC CTAX STK INFL

All firms 1982–87 72 2.69 5.88 0.44 45.50 25.331988–91 48 1.40* 6.65* 0.42 35.50* –23.50* 5.42*

Non-NOL firms 1982–87 60 3.05 6.01 0.41 — — —1988–91 40 1.51* 6.85* 0.38 — — —

NOL firms 1982–87 12 0.92 5.23 0.58 — — —1988–91 8 0.84 5.62 0.60 — — —

Canada

Group Period N*T LEV SIZE DSEC CTAX STK INFL

All firms 1968–71 648 1.35 4.09 0.45 49.01 0.78 0.691972–77 972 1.65* 4.69* 0.43* 47.63 0.25 –0.49

NOL firms 1968–71 188 1.33 3.58 0.40 — — —1972–77 282 1.81* 3.94* 0.36* — — —

High growth firms 1968–71 92 2.01 3.24 0.45 — — —1972–77 138 2.46 4.28* 0.43 — — —

High dividend firms 1968–71 104 0.87 4.90 0.54 — — —1972–77 156 1.11* 5.37* 0.51 — — —

All other firms 1968–71 264 1.32 4.44 0.44 — — —1972–77 396 1.47 5.09* 0.44 — — —

Notes: An asterisk indicates that the mean of the variable over the postintegration period is significantly differentfrom the mean over the preintegration period at a 5 percent level of significance. N*T is the total number ofobservations. N is the number of firms in each group, and T is the number of years.

In the New Zealand sample, the sample sizes for the macroeconomic variables (CTAX, STK, and INFL), which areidentical for all firms, are six and four years for the preintegration and postintegration periods, respectively. Due todata availability constraints, these sample sizes are reversed in the Canadian data.

–1.27

New Zealand

The first step in the estimation processwas to estimate the least restricted

model by ordinary least squares(OLS) for each firm:

7


44

firm was defined as an NOL firm if ithad a loss on income before taxes duringany year in the ten-year sample period.Two firms were identified as NOL firms,leaving ten firms in the second port-folio.

A pooled version of the above modelwas then estimated using OLS for eachseparate portfolio and the entire sampleof 12 firms. All marginal effects (the β’s)in these pooled models were restrictedto be the same across firms, while theintercepts were allowed to vary (apooled one-way fixed effects model).18

In order to test down from the leastrestricted model to the most appropriatepooled model, pooling tests based onthe sum of squared errors from thepooled and individual regressions wereconducted.19 For the entire sample, thetest of the null hypothesis that poolingis the appropriate model had a P valueof 0.175, such that pooling of the entiresample could not be rejected. Since thetests for pooling of the NOL and non-NOLsubsamples are nested within thepooling test for the entire sample, thisimplies pooling is appropriate for thetwo subsamples as well. In addition,this implies that NOL firms in the NewZealand sample respond to the taxvariables, firm-specific variables, andmacroeconomic variables no differentlythan non-NOL firms.

A final specification test was conductedto test whether the individual firmintercepts were jointly equal to oneanother. Using the same type of testingprocedure as that outlined above, a testof the null hypothesis that individualfirm intercepts were jointly equal to oneanother was easily rejected at the fivepercent level of significance. The finalmodel for purposes of inference is thengiven by

LEVit = αi + β1T INTt + β2CTAXt

+ β3CTAXt*TINTt + β4SIZEit

+ β5DSECit + β6STKt + β7INFLt + εit

which implies identical marginal effectsacross firms while the intercept isallowed to vary by firms.

Canada

For the Canadian sample, equation 7,above (with I = 1,. . .,162 and t = 1968,. . .,1977) was estimated using OLS foreach firm individually and tested forautocorrelation and heteroskedasticity,neither of which were indicated at thefive percent level of significance. Thedivision of the Canadian sample into itsportfolios resulted in 47 NOL firms, 23high growth–low dividend firms, and 26high dividend–low growth firms.Portfolio 4 consisted of the other 66firms which did not meet the criteria ofthe other portfolio designations.

Pooled regressions on each portfolioand the entire sample were estimated todetermine the validity of pooling withineach portfolio subsample. Poolingcould not be rejected at the five percentlevel within each portfolio. However,pooling of the entire sample wasrejected.20 This implies that while firmswithin each portfolio respond nodifferently to changes in the indepen-dent variables, there is a significantdifference in firms’ responses acrossportfolios. In particular, the responsesof high growth and high dividend firmswere found to be statistically differentfrom one another, as well as theresponses of the “average” and NOL

8


45

firms.21 Thus, the final model forpurposes of inference is given byequation 8 applied separately to each ofthe four portfolio groups.

REGRESSION RESULTS

The regression results for the NewZealand and Canadian samples arepresented in Tables 3A and 3B, respec-tively.22 Consider first the effects of thecontrol variables for firm attributes, SIZEand DSEC, and economic influences,STK and INFL.

With the exception of the high dividendgroup in Canada, the estimated effectsof the firm size (SIZE) and debtsecurability (DSEC ) variables werepositive and significant, as would beexpected based on previous research.This indicates that larger and bettercollateralized firms tend to be moreheavily leveraged. For the high dividendgroup in Canada, the SIZE variable had apositive significant effect but theestimated effect of DSEC was found tobe insignificant. Although this group offirms exhibited low earnings growth, their

high return on dividends implies a stableearnings pattern. The insignificance ofDSEC could indicate that high dividendfirms are able to collateralize debt basedon the reputation of consistent earningsrather than fixed assets.

The economic variables capturingchanges in the stock market (STK) andunexpected inflation (INFL) generallyperformed poorly. Only for the highgrowth group in Canada were both ofthese variables significant and in thepostulated direction. However, sensitiv-ity tests indicated that the two variablescould not be omitted from any of themodels. This indicates that the poorperformance of the STK and INFLvariables is most likely due to collinearitybetween the two series.

The variables of primary interest to ourstudy are the tax variables, CTAX andTINT, and the interaction between thetwo. The estimated effect of tax rateson corporate leverage prior to integra-tion is captured by the variable CTAX.For the New Zealand sample, thisvariable had a significant negative effecton corporate leverage. For the highgrowth and all other groups in Canada,however, CTAX had a significant positiveeffect on corporate leverage; this wasnot the case for the NOL or highdividend groups. Recall that CTAXcaptures the effects of both corporateand personal tax rates, which shouldhave opposite effects on corporatefinancing decisions. A positive (nega-tive) estimated effect for CTAX suggeststhat changes in corporate (personal)tax rates have a dominant influence onchanges in corporate capital structure.A nonsignificant estimated effectfor CTAX suggests that neither corpo-rate nor personal tax rates have adominant influence but that theireffects are roughly equal and off-setting.23

TABLE 3AREGRESSION RESULTS FOR NEW ZEALAND

Variable Estimate t Statistic

INTERCEPT 5.020TINT –14.669 –1.739*

CTAX –0.280 –1.498**

CTAX*TINT 0.271 1.478**

SIZE 1.231 3.943*

DSEC 7.554 5.862*

STK –0.007 –0.673INFL –0.028 –0.399N*T 120F statistic 18.316*

R2 0.534

Notes: A single asterisk indicates significance at the 5percent level.A double asterisk indicates significance at the 10percent level.All t tests are one tailed.Reported value for INTERCEPT is the average of firm-specific intercepts.Tests for pooling indicated no portfolio separationrequired.


46

The extent to which the effect of taxrates changed as a result of integrationis captured by the interaction betweenCTAX and TINT (CTAX*TINT ) . 24 Thesignificant, positive coefficient forCTAX*TINT in the New Zealand sampleand the high dividend and all othergroups in Canada suggests thatintegration shifted the influence of taxrates toward the corporate rate. Bycontrast, the significant negativecoefficient for CTAX*TINT in the highgrowth group in Canada suggests a shiftin influence toward personal rates.These results are plausible consideringthe fact that the high growth firms

provide investors a relatively largerreturn in the form of capital gains andthat integration in Canada was accom-panied by the introduction of a tax oncapital gains.

The variable for tax integration (TINT ) issignificant for all groups except theCanadian NOL firms, the group ex-pected to have the least reaction to taxchanges. However, the TINT variablealone does not capture the entire effectof the integration due to a change inthe importance of tax rates afterintegration. To evaluate the full effectof integration, both the TINT variable

TABLE 3BREGRESSION RESULTS FOR CANADIAN PORTFOLIOS

NOL High Growth

Variable Estimate t Statistic Estimate t Statistic

INTERCEPT –3.112 — –8.513 —TINT 3.123 1.184 6.696 1.950*

CTAX –0.002 –0.053 0.155 2.950*

CTAX*TINT –0.060 –1.101 –0.141 –2.001*

SIZE 0.936 5.014* 0.732 3.799*

DSEC 2.967 4.101* 1.248 1.469**

STK –0.001 –0.085 –0.029 –1.417**

INFL –0.014 –0.634 0.047 1.604**

N*T 470 230F statistic 10.265* 6.669*

R2 0.135 0.174

High Dividend All Others

Variable Estimate t Statistic Estimate t Statistic

INTERCEPT –5.190 — –5.141 —TINT –3.115 –3.754* –2.157 –1.678*

CTAX 0.007 0.643 0.027 1.450**

CTAX*TINT 0.059 3.461* 0.037 1.423**

SIZE 1.178 15.101* 0.883 7.570*

DSEC –0.150 –0.675 2.764 5.660*

STK 0.001 0.285 –0.011 –1.467**

INFL –0.009 –1.363** –0.006 –0.541N*T 260 660F statistic 43.74* 18.759*

R2 0.549 0.168

Notes: A single asterisk indicates significance at the 5 percent level.A double asterisk indicates significance at the 10 percent level.All t tests are one tailed.Reported value for INTERCEPT is the average of firm-specific intercepts.Tests for pooling indicated separate portfolio regressions required.


47

and the interaction variable, TINT*CTAX,must be considered. Note that, forevery group of firms, the signs of theTINT and the TINT*CTAX variables areopposite, indicating that tax rate effectsreduce the response of firms to theadoption of integration. The oppositesigns of the TINT and TINT*CTAXvariables are due to the fact that theinteraction variable changes the slope ofthe regression line. A positive estimatefor TINT*CTAX indicates that theregression line rotates counterclockwise,thereby reducing the intercept. Furthertesting, described below, is necessary tomeasure the combined effects ofintegration and the change of theimpact of tax rates due to integration.

The estimated impact of integration ondebt-to-equity ratios is reported in Table4 in gross and percentage terms. TINTmeasures any change in the level of thedependent variable (a change in theintercept of the regression equation),and CTAX*TINT measures any change inthe marginal effect of tax rates on thedependent variable (a change in theslope of the regression equation). Since,through these two variables, integra-tion may affect both the slope and theintercept of the regression equation, themeasurement of the impact of integra-tion must be made with reference to aspecific value of the CTAX variable. Tosimplify comparisons across groups andto facilitate the calculation of percent-age effects, the impact of integration isestimated at the mean of the indepen-dent variables over the postintegrationperiod.25 Conceptually, the mean grosseffect of integration is an estimate ofthe difference between actual meandebt-to-equity ratios over thepostintegration period and the meandebt-to-equity ratios that, ceterisparibus, would have occurred in theabsence of integration.

The mean gross effects reported in Table4 indicate that integration had asignificant negative impact on debt-to-equity ratios for firms in New Zealandand for the high dividend and all othergroups in Canada. For the New Zealandsample and the high dividend and allother groups in Canada, the negativeeffect of integration on the regressionintercept was only partially offset by thepositive effect of integration on theslope of the regression equation.Hence, the estimated mean gross effectof integration for these groups wasnegative and significant, implying that,

TABLE 4ESTIMATED EFFECTS OF INTEGRATIONa

Impact on PercentageDebt-to- Difference inEquity Debt-to-EquityRatios Ratios(Mean (MeanGross Percentage

Portfolio Group Effectb) Effectc)

New Zealand –5.030 –78.197(0.020) (0.001)

Canada – NOL 0.261 16.917(0.071) (0.229)

Canada – –0.027 –1.072High growth (0.913) (0.912)

Canada – –0.315 –22.158High dividend (0.001) (0.001)

Canada – –0.379 –20.441All others (0.001) (0.001)

P values in parentheses.aCombined effects of integration (TINT ) and tax rates(CTAX*TINT) on debt-to-equity ratios (LEV ).bThe mean gross effect is calculated as the differencebetween the predicted value of debt-to-equity ratios(LEV ) net of the effects of integration and the actualvalue for the postintegration period, computed at themean of tax rates (CTAX) for the postintegrationperiod. The P values in parentheses are based uponan F test of whether the mean gross effect issignificantly different than zero.c The mean percentage effect is the mean gross effectexpressed as a percentage change in the actual valueof LEV relative to its predicted value in the absence ofintegration. The P values in parentheses are based ona nonlinear Wald test of whether the meanpercentage effect is significantly different than zero.


48

in the absence of integration, meandebt-to-equity ratios would have beenhigher by the amount shown in Table 4.

For the NOL group in Canada, notefrom Table 3B that neither the TINT northe CTAX*TINT variables were significant.Thus, integration had no significanteffect on mean debt-to-equity ratios forthis group. This is not surprising in thatone would not expect firms with lowmarginal tax rates to be as responsive tochanges in tax policy.

For the high growth group, both theTINT and the CTAX*TINT variables weresignificant (Table 3B), while the meangross effect (Table 4) was not. For thisgroup, the significant positive effect ofintegration on the regression interceptwas, at the point of estimation, com-pletely offset by the significant negativeeffect of integration on the slope of theregression equation. Hence, if theimpact of integration had been estimatedat a slightly lower (higher) marginal taxrate, integration would have had asignificant positive (negative) impact ondebt-to-equity ratios in the high growthgroup.

Although the mean gross effects ofintegration provide an indication of thesignificance of this change in tax policywith regard to corporate financingdecisions, it is more meaningful toconsider the effects of integration inpercentage terms. The mean percent-age effects of integration can becalculated by comparing the actualvalues of the dependent variable tothose that would be predicted by theregression models in the absence ofintegration.26 The results presented inTable 4 indicate that mean debt-to-equity ratios were 78 percent lower inNew Zealand than what they wouldhave been in the absence of integration.Similarly, for the high dividend and allother groups in Canada, mean debt-to-equity ratios are 22 and 20 percentlower, respectively, than those predicted.As with the mean gross effects, themean percentage effects showed nosignificant change in debt-to-equityratios for the NOL and high growthgroup in Canada. These relationshipsare depicted graphically for NewZealand (Figure 1a) and all Canadianfirms except NOL firms (Figures 1b–1d),both for actual and predicted results.27

FIGURE 1a. Observed and Predicted Mean Debt-to-Equity Ratios by Year and Subperiod

LEV0 is the mean of observed debt-to-equity ratios over the preintegration period.LEV1 is the mean of observed debt-to-equity ratios over the postintegration period.LEV2 is the mean of predicted debt-to-equity ratios over the postintegration period less integration effects.


49

FIGURE 1b.

FIGURE 1c.

FIGURE 1d.

LEV0 is the mean of observed debt-to-equity ratios over the preintegration period.LEV1 is the mean of observed debt-to-equity ratios over the postintegration period.LEV2 is the mean of predicted debt-to-equity ratios over the postintegration period less integration effects.


50

Conclusion

The results of this study provide evi-dence that the adoption of corporatetax integration will produce one of itsdesired effects—the reduction ofcorporate debt relative to equity.However, the impact of integration oncorporate leverage is very sensitive totax rates, particularly to taxes on capitalgains. New Zealand’s experienceprovides strong evidence that theshareholder-credit system of integration,in the absence of confounding tax lawchanges, will significantly decreasecorporate leverage. In Canada, where theeffects of integration were mitigated byan increased capital gains tax, asignificant decrease in leverage wasobserved in most firms. No significantreaction was observed in firms withexcess tax shields (NOLs). For lowdividend-paying firms providing returnto investors primarily through growth,no significant reduction in debt-to-equity ratios was detected only becauseof the offsetting effects of integrationand changes in tax rates. The Canadianexperience indicates that an increase incapital gains taxes can reduce thebenefits of integration.

Although this study shows that taxpolicy changes can reduce corporateleverage, this is not the ultimate goal ofintegration. A nation profits only ifthese benefits translate into an im-proved economy. Advocates of integra-tion argue that removing tax distortionswill reduce economic costs, resulting inincreased capital accumulation andsavings (AICPA, 1992, p. 2; U.S. Treasury,1992, p. 12). The observed reduction incorporate leverage caused by integrationis only the first link in this chain of events.Further research should reveal whetherintegration’s reduction of corporate debtresults in increased investment for theadopting country.

Also, the restructuring of corporatefinancing following integration is notdirectly explained. Clientele effects maybe the primary reason for the changes incorporate leverage, which may or maynot reflect a reduction in the total costof capital for these firms. If the benefitsof integration are extended to foreigninvestors, the observed change incorporate financing could reflect a shiftin the source of funds from foreign todomestic markets (Boadway and Bruce,1992). Of further interest would be theimpact of integration on the differentialreturns to investors as a measure ofthese clientele effects.

A note of caution is needed in general-izing the specific results of our study toother countries. Graham and Bromson(1992) determined that there existsignificant country-specific influences oncorporate leverage. Such country-specific influences, believed to arisefrom differing state-finance-industryrelationships, probably explain much ofthe observed difference between themean debt-to-equity ratios of thesamples in these two countries bothbefore and after integration. Further-more, the adoption of integration in anycountry may differ by a multitude offactors, such as time, political climate,and economic environment.

Despite these limitations, the findingsprovide empirical support for theoreticalarguments and prior econometricresearch. First, the imputation creditmethod of integration can reducecorporate financial leverage, lendingsupport to the findings of Boadway andBruce with regard to the theoreticaleffects of integration on corporatefinancial structure (1992). Second, thisfavorable impact is diminished byincreased taxes on gains realized throughstock appreciation. These are importantconclusions for the United States, which


51

is considering both integration and thereintroduction of preferential taxtreatment for capital gains.

ENDNOTES* The University of Arkansas authors would like to

thank the Ernst & Young Foundation and the TaxFoundation for their support of this research.

1 Hereafter, unless otherwise indicated, the term“capital gains” refers only to gains realized on thesale of corporate stocks. Examination of taxeslevied on other capital assets is beyond the scopeof this study.

2 Actual calculation of the grossed-up dividend andof the credit received by the shareholder variesamong countries. The U.S. Treasury studydiscussed, but rejected, the adoption of animputation credit method of integration patternedafter the system in New Zealand (U.S. Treasury,1992, p. 95–106). On the other hand, the AICPA(1992) recommends this method. Other countriesadopting the shareholder credit method ofintegration include Australia (1987), France (1965),Italy (1977), and the United Kingdom (1973). In1977, Germany supplemented its split-rate methodof integration with a shareholder credit. SeeAvi-Yonah (1990).

3 Other major changes in New Zealand tax laws in1988 included a new system of trust taxation andchanges in the provisional tax system (CommerceClearing House, 1989, p. 11).

4 In Canada, the calculation of the shareholder creditis not dependent upon the amount of taxes paidby the corporation, such that “super” integrationis possible.

5 Another change in Canadian tax laws was therepeal of federal estate and gift taxes. Prior to1972, capital gains had been included in the estateat the time of death for estate tax purposes.Subsequent to 1971, capital gains are included inthe final income tax return.

6 Under the Counter-Inflation Act of 1973, the BritishTreasury limited dividends by publicly tradedcompanies, as well as shareholder credits thereon.Thus, the potential use and tax benefit of theshareholder credit were severely diminished.

7 While the present paper does not address theissues of investment, savings, or the organizationof the firm, it does provide some direct evidenceon the ability of integration by means of ashareholder credit to remove biases in favor ofdebt financing.

8 Substituting λTi for Td in equation 3, it isstraightforward to show that (∂CD/∂Ti) > 0 if λ < 1.In addition, this effect is strictly greater than themarginal effect of personal taxes when λ = 1; aclassical tax structure.

9 Although a 12-firm sample may seem small forpurposes of inference, it should be noted that,over the sample period under investigation, thecombined pretax income of these 12 firmsconstituted 0.5–4.3 percent of New Zealand GDP.By comparison, the combined pretax income of theCanadian sample (162 firms) constituted 0.9–2.0percent of Canadian GDP.

10 While ten years of data is included for bothCanada and New Zealand, limitations on theavailability of data cause a difference in the timeperiod before and after integration. For NewZealand, six years of data exists prior tointegration, with four years after. For Canada,this division is reversed, with four years of dataavailable prior to integration and six yearsafter.

11 Note that any firm with a negative equity would bedeleted under these guidelines.

12 None of the debt-to-equity ratios in the NewZealand data fell outside the 0.05–20 range, andno firms were deleted.

13 Analysis revealed a high correlation betweenindividual tax rates and corporate tax rates in NewZealand (r = 0.79) and Canada (r = 0.61).Provincial rates in Canada, also highly correlated,are disregarded for the same reason.

14 The return from dividends was defined as totaldividends declared (common and preferred)divided by book value of equity. The growth inretained earnings was defined as income beforetaxes and interest less total dividends divided bybook value of equity.

15 The series used for this model are the GDP deflatorfor the price level, the index of manufacturingwages, and the index of the unit value of importsas reported by the IMF. The price level, index ofwages, and index of import prices enter in logform. The regression model incorporated 25annual observations (1963–87) and included acorrection for autocorrelation. See Taylor (1993,pp. 78–9) for a more complete discussion of themodel.

16 The pooled model is restricted in the sensethat slope parameters, or the marginal effects ofthe independent variables, are held constantacross individual firms. The testing downprocedure herein employed ensures that theserestrictions are consistent with the data. Thenormal tests of specification related to time-series(autocorrelation) and cross-sectional(heteroskedasticity) data will identify a misspecifiedmodel.

17 For each firm, autocorrelation andheteroskedasticity were tested using theDurbin-Watson and White (1980) tests,respectively. The null hypotheses of noautocorrelation and no heteroskedasticity couldnot be rejected at the five percent level ofsignificance. This implies that the regression


52

equation represented by equation 5 is wellspecified insofar as there are no systematicinfluences captured by the error term.

18 Using the White (1980) test, each pooled modelwas tested for heteroskedasticity, the absence ofwhich could not be rejected at the five percentlevel of significance. There is no need to test forautocorrelation in the pooled models since thishypothesis was rejected in the least restrictedmodel given by equation 5. However, poolingimposes an auxiliary restriction that the variance ofthe error term is the same across firms. The factthat heteroskedasticity was absent in the pooledmodels indicates that the data are consistent withthe restriction of equal variances.

19 These tests are related to the likelihood ratio testand are distributed as F statistics with numeratordegrees equal to the number of restrictions anddenominator degrees of freedom equal to thedegrees of freedom in the unrestricted model. SeeGreene (1993, p. 206) for a description of thetesting procedure.

20 The test statistics for pooling within portfolios hadcalculated values of 1.171 (0.146), 1.442 (0.075),1.388 (0.084), and 1.099 (0.227) for the NOL,high growth, high dividend, and all other groups,respectively (P values in parentheses). The teststatistic for pooling of the entire sample had acalculated value of 3.843, implying a P value nearzero.

21 For each pooled portfolio model, the hypothesis ofno heteroskedasticity was tested using White’s testand could not be rejected at the five percent levelof significance. In addition, the hypothesis ofidentical firm intercepts within each portfolio wastested and rejected at the five percent level ofsignificance.

22 The figures reported for the intercept in Tables 3Aand 3B are averages of the firm-specific intercepts.Estimates of the firm-specific intercepts and theirassociated t statistics are excluded in the interest ofbrevity but are available from the authors uponrequest along with details of the autocorrelation,heteroskedasticity, and pooling tests discussedabove. The relatively large estimates of theregression intercepts (relative to mean LEV ) aresimply a matter of scaling. By scaling totalassets up or down by a factor of 1,000 (measuringtotal assets in millions of thousands), theregression intercepts could be shifted to nearzero without changing the qualitative interpreta-tion or quantitative estimates of the impact ofintegration/capital gains on mean debt-to-equityratios.

23 Since the effects of corporate and personal taxrates cannot be separated within the presentframework, a nonsignificant coefficient for CTAXwould also support the hypothesis that neithercorporate nor personal tax rates influencecorporate financing decisions.

24 The marginal effect of changes in tax rates afterintegration is found by summing the coefficientson CTAX and CTAX*TINT. For the New Zealandsample, this results in an estimated effect of–0.008 (0.872). For the Canadian samples, theestimated effects were –0.062 (0.146), 0.014(0.822), 0.066 (0.001), and 0.064 (0.005) forthe NOL, high growth, high dividend, and allother groups, respectively (P values inparentheses).

25 Letting CTAXM denote the mean of CTAX overthe postintegration period and using theparameter specification defined in equation 8,the mean gross effect of integration is calculatedas β̂1 + β̂2 CTAXM, where β1 and β2 are thecoefficients on the TINT and CTAX*TINT variables,respectively, and a hat (^) denotes an estimatedvalue. Calculating the mean gross effect ofintegration using this method is identical tocalculating the effect of integration for each yearover the integration subperiod and taking theirmean.

26 The mean percentage effect of integration can becalculated as 100*(LEV1 – LEV2)/LEV2, where LEV1

is the mean of observed debt-to-equity ratiosand LEV2 is the mean of predicted debt-to-equityratios net of the effects of TINT and CTAX*TINT,both over the postintegration period. Whencalculated in this manner, the mean percentageeffects of integration can be written as a functionof the means of the independent variables overthe integration subperiod and the estimatedregression parameters, which facilitates a test ofsignificance using a nonlinear Wald statistic.See Greene (1993, p. 132) for a description of theuse of the Wald statistic to test nonlinearrestrictions.

27 Because the TINT and CTAX*TINT variables areinsignificant for NOL firms, the graph for thisgroup is omitted.

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American Law Institute, Federal Income TaxProject. Tax Advisory Group’s Draft No. 21,Reporter’s Study. Philadelphia: ALI, 1992.

Amoako-Adu, Ben. “The Canadian Tax Reformand Its Effect on Stock Prices: A Note.” TheJournal of Finance 38 No. 5 (December, 1983):1669–75.

Amoako-Adu, Ben, Muhannad Rashid, andM. Stebbins. “Capital Gains Tax and EquityValues: Empirical Test of Stock Price Reaction to


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