Does the tax deductibility of interest affect financial reporting?

Abstract

Many countries have imposed tax policies that limit interest deductions to specified leverage ratios to fight aggressive income shifting and to achieve other public policy goals. Implementing these thin capitalization tax rules reduces the incentives to use debt unrelated to the relation between the firm and its debtholders. We posit that, as a result of the effect of the rules on debt levels, firms subject to these rules reduce their conservative financial reporting as compared to other firms in these countries. Tests employ a large sample of firms in OECD countries who introduced thin capitalization rules from 1985 to 2014, and a second sample of U.S. firms around the implementation of earnings-based interest limits under the Tax Cuts and Jobs Act. Exploiting these two settings and difference-in-differences research designs, we provide evidence that the adoption of tax deductibility limits reduces conditional conservatism of firms’ financial reporting. Our findings suggest that the tax rules affecting the deductibility of interest have important impacts on corporate financial reporting and may also have unintended consequences for other decisions of interest to policy makers.