Crowding-out or shying-away: impact of corporate income tax on capital structure choice of firms in Pakistan

Abstract

This article aims to investigate whether corporate income taxes affect the capital structure of nonfinancial firms listed on Karachi Stock Exchange Pakistan during 1972–2010. Empirical results suggest that taxes are positively related to total debt ratio and short-term debt ratio, whereas they are negatively related to long-term debt ratio. The negative relationship between taxes and long-term debt ratio appears illogical considering the tax advantage of debt in the presence of the corporate income tax. However, the observed crowding-out of corporate debt financing due to the presence of nondebt tax shields provides some logic on the demand side. While on the supply side the banks shy away from long-term debt in peculiar socioeconomic realities of Pakistan. The mixed relationships of corporate income tax with different measures of capital structure partially confirm the prophecy of trade-off theory in Pakistan. In addition, we find that other firm-specific variables which appear to significantly influence the capital structure choice of firms are profitability, collateral value of assets and firm size.

Keywords:

• capital structure
• corporate income tax
• trade-off theory
• pecking order theory
• Pakistan

JEL Classification:

• G29
• G30
• G32

Notes

¹ Namely, cement, chemicals, engineering, fuel & energy, jute, paper & board, sugar & allied industries, textile, other textile (ancillary textile products), tobacco, transport & communication, vanaspati and miscellaneous.