Taxes and Security Design: A Public Finance Rationale for Tax Differentiated Corporate Securities

Abstract

This paper provides a link that integrates public finance and corporate finance. We analyze a world in which costly tax avoidance or evasion could occur. The class of solutions considered here involve changes in the tax system that economize on the deadweight costs of avoiding taxes and monitoring potential evaders. Our results show that if corporate reported income could be partitioned into differentially taxed components, the value maximizing firm would choose to report taxable income more truthfully and pays higher aggregate taxes. A prime example is the partition between nondeductible equity distribution and deductible debt interest. The paper provides a security design rationale for the tax deductibility of interest expense.

JEL Classification: G30, H20