Taxation

TAXATION

The first point to note about taxation is that in virtually every country of this study (with the possible exception of Finland) debt finance has been favored over equity. This stands in marked contrast to the universal preference for equity finance (including retentions) over debt finance. More generally, in records a poor relation between tax incentives to employ different forms of finance in the eight countries of the study and actual financing proportions. On the left-hand side, table ranks the tax incentive to use debt in preference to retentions, new equity issues in preference to retentions and new equity in preference to debt. Countries at the top have the highest incentive to use the first form of finance in each case. On the right-hand side, it reports actual financing proportions of this paper. 

The most striking country in the first  Germany, which has the highest incentive to use debt in relation to retentions and the second lowest use of debt relative to retentions. The United Kingdom has the lowest debt-to-retentions ratio and the third highest tax incentive. The picture is not very much better for the ratio of new equity to retentions where Germany now has the third lowest new equity proportion and the highest incentive and the United Kingdom still has the lowest proportion and the fourth highest incentive. It might be objected that comparisons of internal and external financing proportions and incentives are distorted by transaction costs and investment requirements. 


The third part of the table may therefore be regarded as more instructive. There the most striking case is Finland, which has the highest incentive to use new equity in preference to debt and the second lowest proportion. 


There are several objections that can be raised against this type of comparison. There are well-known problems in comparing tax incentives across countries. The figures on which are based come from an OECD extension of the King-Fullerton (1984) study. These derive tax incentives created by both corporate and personal taxation on the basis of a Modigliani and Miller (as against a Miller) equilibrium model of the economy. 

They do not 322 Colin Mayer take account of cross-border tax incentives to locate, finance, and invest in different countries, and they have been found to be very sensitive to respecifications of the model. In addition, the tax incentives in the OECD study relate to investment in equipment, not structures, and tax-exempt institutions, not households. In fact, the ranking of incentives is virtually identical for structures and equipment but is sensitive to the assumed tax rate of investors.


Finally, the tax incentives refer to one year, 1983, while the financing proportions are averages over the period of the study, 1970-85. Averaging over the period 1982-84 revealed that the ranking of external to internal financing proportions is similar around the date of measurement of tax incentives. Despite all these possible sources of inaccuracy, there would have to be a remarkable level of mismeasurement for taxation to provide a credible explanation for observed financing proportions.