Corporate taxation and financial strategies under asymmetric information

Abstract

In this article, we study the effects of corporate taxation on credit market equilibria in presence of asymmetric information. We develop a screening model that accounts for the following five facts: the existence of a tax incentive to borrow, the presence of asymmetric information in credit markets, the screening activity of lenders, the negative relationship between leverage and profitability, and the business cycle effects on the spread between high-yield and investment-grade interest rates on corporate loans. Assuming the existence of two types of firms, we show that either a separating or a pooling credit market equilibrium can arise, depending on the level of taxation. Finally, we analyze the joint effects of business cycle and taxation on the credit market equilibrium.