The impact of tax policy on corporate debt in a developing economy: a study of unquoted Indian companies

Abstract

Taxation has potentially important implications for corporate behaviour. However, there have been few studies of the impact of taxation on companies in developing countries, and fewer still concerned with unquoted companies. In this paper, we study the impact of tax policy on the financial decisions of a sample of unquoted companies in India during the period 1989–99 when tax rates were generally reduced as part of a wider programme of financial liberalization. We examine the impact of the tax regime on company financing decisions, within the context of a model of company leverage, controlling for non-tax influences suggested by the theory of corporate finance. The analysis is carried out using a balanced panel consisting of the published accounts of 97 Indian unquoted companies, which reported continuously during 1989–99. The model is estimated using Generalized Methods of Moments (GMM). Estimates of the impact of the 1990s tax reforms are derived, and implications for policy are drawn.

Keywords:

• India
• corporate finance
• taxation

Acknowledgements

We thank Joy Suppakitjarak for valuable research assistance; and the referees and editors of the European Journal of Finance for their many comments which have helped improve the paper. Earlier drafts of this paper were presented at the International Conference on “Finance for Growth and Poverty Reduction: Experience and Policy”, held at Manchester University on April 10–12, 2002, and funded by DFID; and at the MMF/UEM conference at the University of Warwick on September 4–6 2002. We thank participants in these conferences for their useful comments. The research underlying this paper forms part of a general research programme on finance and development funded by DFID. We thank DFID for their financial support. The interpretations and conclusions expressed in this paper are entirely our own and should not be attributed in any manner to DFID.

Notes

Quoted firms may not necessarily adhere to exchange disclosure requirements. This has been an issue for the Bombay Stock Exchange (BSE), but non-compliance can lead to suspension of the shares by the BSE. We are indebted to an anonymous referee for this point.

In a related paper we investigate the impact of tax policy on a sample of quoted companies: Green and Murinde (2003).

For a general overview of India in the 1990s, see the collection of essays in Ahluwalia and Little (1998), especially Singh (1998).

King was analysing the then-current UK corporate tax system. Thus, he did not distinguish between the tax rates on dividend and interest income. However, King's original conditions are easily amended to arrive at the formulas given in the text.

Booth, Aivazian, Demirguc-Kunt, Maksimovic used the effective tax rates in a set of individual country regressions. However, in a separate cross-country regression they used instead King's debt-equity condition.

Allowing for loss carryovers, a simple dichotomous (Plesko) or trichotomous (Graham) variable is a good approximation to the ‘true’ simulated marginal rate in the US.

Firms which reported negative net worth were technically bankrupt under Indian law. Such firms, once registered, with the statutory Board for Financial and Industrial Reconstruction as “sick”, effectively cease operations until a reorganisation plan is proposed and agreed by the Board. For further details see Goswami (1996) and (2000). We are indebted to an anonymous referee for this point.

Data corresponding to account years of between 7 and 11 months were adjusted to a 12 month basis. However, the regressions were also run separately using the unadjusted data and there were no major differences in the results.

For example, company size was calculated by deflating sales by the consumer price index. Companies reporting at end-March were deflated by the March consumer price index, those reporting at end-June were deflated by the June price index and so on.

These figures may somewhat exaggerate the importance of business groups for two reasons. First, reporting standards within a group are likely to be superior to those within stand-alone companies. Thus, our sample selection procedure may over-represent group companies. Second, since most Indian companies do not produce consolidated accounts, some companies which, according to our data, belong to a business house may in fact be majority-owned subsidiaries.

All our data are measured at book value as there are evidently no market value data available for unquoted companies.

For example, provisions for tax and dividends are funds set aside from the current financial year, but they are paid in the following year.

The more commonly-used market-to-book ratio is not applicable here as, by construction, we have no market values.

Value added is preferred to profits because reported profits may contain idiosyncratic components which are unrelated to business activity during the accounting year. Value added is a better reflection of underlying economic profit.

The material in this section is derived particularly from: Income Tax Department (2001), Institute of Chartered Accountants of India (2000), Price Waterhouse (1996), and Taxmann's Companies Act (2000).

The tax year runs from April to end-March. A distinction is made between the assessment year and the financial year. Income accrued in any given financial year is taxed at the rates applicable to that year. However, the tax for that year is assessed and payment finalized in the following year, which is the assessment year. Dates in the text refer to financial years ending in March.

The top rate of tax became payable at annual incomes of Rs100,000 through 1992; Rs120,000 through 1997; and Rs150,000 thereafter.

Two further features of company taxation not modelled in this paper are as follows. First, closely-held companies were subject to a higher rate of tax than more widely-held public companies until April 1994 when the rates were unified. Second, since April 1996, companies have been subject to a Minimum Alternative Tax. This is levied if the taxable income of a company calculated according to the standard provisions of the tax act is less than 30% of its book profits.

Long-term gains are those on assets held for more than 3 years (one year for listed securities or mutual fund units). Gains on assets held for a shorter period and those on which depreciation is charged are short-term.

R& D is only available for a subsample of firms; export profits are not reported at all; and book depreciation may bear only a tenuous relationship to tax depreciation. We initially used estimates of depreciation and export profits in the model, but their coefficients were mostly positive, suggesting mis-specification. We therefore aggregated all non-debt tax shields as explained in the text.

Ziliak studied a sample of 5320 observations.

A full set of OWIV estimates is available from the authors on request.

The exceptions, GDA3 and GDE3, are mostly not significant.