Do Equity Tax Shields Reduce Leverage? The Austrian Case

The goal of this article is to analyze the impact of equity tax shields, that were allowed in Austria from 2000 to 2004, on the capital structure of Austrian firms, both at book values and at market values. We see that the choice of the leverage ratio determines whether or not one can find an impact of equity tax shields on the capital structure of firms. Precisely, equity tax shields reduce the long-term liabilities to assets ratio and on the long-term liabilities to long-term capital ratio, but have no impact on the total liabilities to assets ratio. Although the Austrian system granted only a rather small dose of equity tax shields, we find that the tax regime achieved its goal to reduce the leverage (ignoring short-term liabilities). Interestingly, even though it is the book value capital structure that determines the size of equity tax shields, this effect was slightly stronger and more significant for the capital structure at market values than for the book value capital structure. We find that the government could influence the capital structure by changing the level of the equity interest rate allowed. We observe that small firms reduced their capital structure more in response to equity tax shields than big firms. Similarly, we find that firms that were included in the Austrian Traded Index (ATX) did not react to equity tax shields. By contrast, firms that were not included in the ATX strongly reacted to the equity tax shields. Moreover, we find that financial firms did not react to the equity tax shields whereas non-financial firms showed at least some reaction. In addition, with this equity tax shield regime we find strong evidence against the debt substitution hypothesis of De Angelo/Masulis (1980).