How U.S. firms adjusted capital structure after the Tax Cuts and Jobs Act: Empirical evidence

Research Question: This paper investigates how a firm responds to tax reforms on corporate capital structure decisions. The TCJA 2017 represents one of the most significant tax reforms in the U.S. history, reducing the corporate income tax rate from 35 per cent to 21 per cent while introducing some major provisions, such as bonus depreciation, interest deductibility limits, and restrictions on NOL carry forward, which could have a joint effect on corporate capital structure decisions. Based on traditional capital structure theories, we hypothesized that such a significant tax rate reduction, including the addition of some restrictive provisions, would motivate companies to rely less on debt financing relative to internal financing or equity financing due to decreased tax shield benefits. Methodology: To test our hypotheses, we employ a panel regression model with firm and year-fixed effects. Our sample consists of 42,598 firm-year observations spanning from 2014 to 2020. We utilize multiple proxy measures for capital structure decisions, including short-term debt ratio, long-term debt ratio, and total leverage. We control for firm-specific factors that might influence capital structure choices. We conduct additional analyses based on firms’ financial distress levels (using Altman’s Z-score) and financial flexibility, measured by cash holdings. Findings: Contrary to expectations derived from static trade-off theory, we find that firms’ dependence on external sources financing increases in post-reform periods relative to pre-reform periods. The positive relation between tax reform and short-term financing is more pronounced in financially distressed firms, while safer firms tend to decrease their reliance on short-term financing in the post-reform periods. In contrast, firms with greater financial flexibility exhibit greater reliance on long-term debt in post-reform periods than less financially flexible firms. Originality/Value: This study provides the first comprehensive empirical investigation of TCJA 2017’s impact on corporate capital structure decisions. Our findings contribute to the capital structure literature by providing evidence consistent with dynamic trade-off theory rather than static trade-off models. The results have important implications for policymakers evaluating the effectiveness of tax reforms in influencing corporate financial behavior and for corporate financial managers making capital structure decisions in changing tax environments.