Debt and Creative Destruction: Why Could Subsidizing Corporate Debt be Optimal?
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.
We thank Raj Chetty, Douglas Diamond, Peter DeMarzo, Raghu Rajan, Amit Seru, Rob Vishny and the participants of the Chicago Booth Finance Lunch and Chicago Booth Applied Theory seminar for helpful comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
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