Debt and Creative Destruction: Why Could Subsidizing Corporate Debt be Optimal?

Zhiguo He, Gregor Matvos

NBER Working Paper No. 17920
Issued in March 2012
NBER Program(s):Corporate Finance, Industrial Organization, Public Economics

We illustrate the welfare benefit of tax subsidies to corporate debt financing. Two firms engage in a socially wasteful competition for survival in a declining industry. Firms differ on two dimensions: exogenous productivity and endogenously chosen amount of debt financing, resulting in a two dimensional war of attrition. Debt financing increases incentives to exit, which, while socially beneficial, is costly for the firm. Therefore the planner can increase welfare by subsidizing debt financing. The duration of industry distress determines the tradeoff between the welfare benefit illustrated in our model and the costs of subsidizing corporate debt from the existing literature. Our theory also sheds light on why the IRS considers "conflict of interest" as one of the key determinants in identifying securities that are qualified for tax-benefits.

Acknowledgments

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Document Object Identifier (DOI): 10.3386/w17920

Published: Zhiguo He & Gregor Matvos, 2016. "Debt and Creative Destruction: Why Could Subsidizing Corporate Debt Be Optimal?," Management Science, vol 62(2), pages 303-325. citation courtesy of

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