metadata: authors: 0: author: Klapper, Leora
1: author: Tzioumis, Konstantinos
count: World
docna: 0: docna: Taxation and capital structure : evidence
            from a transition economy
docty: Policy Research Working Paper
theme: Other financial and private sector development
subtopic: Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Public Sector Economics,State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,International Trade and Trade Rules,Public Finance Decentralization and
            Poverty Reduction,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,Access to Finance,De Facto Governments
teratopic: Macroeconomics and Economic Growth,Finance and Financial Sector Development,Private Sector Development
abstracts: cdata!: The authors examine the effects of
            taxation on financing policy using the corporate tax reform
            in 2001 in Croatia as a natural experiment. Since the extant
            literature on tax effects on capital structure studies
            listed firms in developed countries, it is worth
            investigating whether the same results apply to
            privately-held, small and medium size firms in transition
            economies. The findings provide significant evidence that
            lower taxes have affected the capital structure of Croatian
            firms, resulting in increased equity levels and decreased
            long-term debt levels. The authors also find that smaller
            and more profitable firms were more likely to reduce their
            debt levels. These findings are consistent with the
            trade-off theory of capital structure, which suggests that
            lower taxes decrease the incentive to hold debt due to
            decreasing interest tax deductibility.
repnme: repnme: Taxation and capital structure : evidence
            from a transition economy
display_title: Taxation and capital structure :
            evidence from a transition economy
listing_relative_url: /research/2008/10/9950512/taxation-capital-structure-evidence-transition-economy
topicv3: State Owned Enterprises m1326323 721,Trade m1326924 698,Access to Finance m1327464 1249,Taxation m1327615 1121,Tax Simplification m1504614 2527
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Finance and Financial Sector Development,Private Sector Development
no_of_pages: 24
model_extractions: WPS4753 Policy ReseaRch WoRking PaPeR 4753 Taxation and Capital Structure Evidence from a Transition Economy _Leora Klapper Konstantinos Tzioumis_ The World Bank Development Research Group Finance and Private Sector Team October 2008
Policy ReseaRch WoRking PaPeR 4753

# **Abstract**

The authors examine the effects of taxation on financing policy using the corporate tax reform in 2001 in Croatia as a natural experiment. Since the extant literature on tax effects on capital structure studies listed firms in developed countries, it is worth investigating whether the same results apply to privately-held, small and medium size firms in transition economies. The findings provide significant evidence that lower taxes have affected the capital structure of Croatian firms, resulting in increased equity levels and decreased long-term debt levels. The authors also find that smaller and more profitable firms were more likely to reduce their debt levels. These findings are consistent with the trade-off theory of capital structure, which suggests that lower taxes decrease the incentive to hold debt due to decreasing interest tax deductibility.

This paper—a product of the Finance and Private Sector Team, Development Research Group—is part of a larger effort in the department to study SME finance. Policy Research Working Papers are also posted on the Web at http://econ. worldbank.org. The author may be contacted at lklapper@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **T AXATION AND C APITAL S TRUCTURE: E VIDENCE FROM A T RANSITION E CONOMY**

## LEORA KLAPPER * KONSTANTINOS TZIOUMIS

_Development Research Group The World Bank 1818 H Street, NW Washington, DC 20433, USA Email:lklapper@worldbank.org_ _Hellenic Observatory European Institute London School of Economics London, WC2A 2AE, UK Email: k.tzioumis@lse.ac.uk_ _Keywords_ : Capital structure, Taxation, Transition Economies _JEL classification_ : G32, G38, K34

> * Corresponding author.  The authors thank Thorstern Beck, Jennifer Blouin, Valentina Bruno, Stijn Claessens, Asli Demirguc-Kunt, Christian Leuz, Sanja Madzarevic-Sujster, and Vassilis Monastiriotis for helpful comments. The opinions expressed do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent.
# **I. INTRODUCTION**

During the past decade, there has been a wave of tax system reforms across Eastern Europe. Although economic models predict a variety of effects from corporate taxation in terms of factor allocation, financing choices and investment patterns, there is little empirical evidence from transition economies. Our study contributes in this field by investigating the unique case of Croatia’s corporate tax reform in 2001 and its effect on the capital structure of private firms. Focusing on private SMEs, we find that equity levels were increased while long-term debt levels were decreased following the substantial reduction of the corporate tax rate from 35% to 20%.

Interestingly, among the determinants of capital structure, taxation is probably the most debated. According to the influential trade-off theory of debt, the optimal level of debt in a firm’s capital structure is determined by the balance of the tax shield provided by debt and the present value of financial distress costs (Myers, 2003). More specifically, there is a positive relationship between the corporate tax shield and firm value given that each increase in the debt portion of a firm’s capital structure decreases the after-tax cash flow. On the other hand, when an excessive amount of debt has been accumulated by the firm, it risks default resulting in the transfer of control to the creditors and the incurrence of deadweight costs which further reduce firm value (Frank and Goyal, 2008). Thus, the lower the tax advantages of debt, the lower the optimal debtequity ratio.

Despite the trade-off theory’s straightforward appeal, empirical tests have produced mixed results. More specifically, the empirical evidence for a tax-effect on capital structure has been less than definitive due to (a) the difficulty of calculating accurately the marginal tax benefits, which are influenced by non-debt tax shields and various tax rules, and (b) the limited availability of non-US firm data on statutory corporate tax reforms. Regarding empirical tests, Givoly et al. (1992) find a positive relation between changes in US corporate taxes and changes in leverage, as well as a substitution effect between debt and non-debt tax shields as a result of the Tax Reform Act of 1986. Graham and Harvey (2001) interview 392 CFOs in the U.S. and find that the tax advantage of interest deductibility is of significant concern by CFOs in large, regulated, and dividend-paying firms. Ayers et al. (2001), using a sample of small U.S. firms (i.e., <500 employees), find a negative relationship between the effective tax rate and debt. In particular, they find a negative effect of marginal tax rates on the use of outside debt (loans from 1
non-owners), and no effect of marginal tax rates on the use of inside debt (loans from owners). Notably, this evidence comes exclusively from publicly listed U.S. firms. As with many aspects of firm financing, bankruptcy costs and asymmetric information in financing decisions of firms in transition and developing countries remain unclear (Prasad et al., 2005).

Using data on Croatian firms, this paper contributes to the literature by demonstrating that − in line with the trade-off theory of debt − firms increased their equity levels as a result of a corporate tax reform. In 2001, Croatia drastically cut its corporate tax rate from 35% to 20%, primarily to promote private sector growth and attract foreign investment [Note: The _General Tax Law (NN No. 127/00)_ , that contained the _Law on Corporate Profit Tax_ , was voted in December 2000 and took effect in January 1, 2001]. This exogenous change in the statutory tax rate was immediately translated into a lower effective tax rate (i.e., taxes divided by pre-tax income). Using the sample of Croatian firms in this study, Figures 1 and 2 illustrate how the mean and median effective tax rate dropped substantially, while the ratio of ‘Equity-to-Assets’ increased, after the corporate tax reform. These changes provide an intuitive indication of a possible relation that ought to be tested further controlling for firm characteristics in order to account for firm-specific factors influencing the choice of capital structure.

[Figures 1 and 2 about here] The remainder of the paper is structured as follows. Section II outlines the motivation for this study, while Section III describes the sample design and estimation methodology. Section IV presents the findings and Section V concludes.

# **II. MOTIVATION**

There are several reasons why the Croatian corporate tax reform offers a unique natural experiment on the impact of corporate taxes on firms’ capital structure choice due to decreased interest tax deductibility: _First_ , cases of substantial corporate tax changes without concurrent changes in personal taxation are unusual, and economic research has traditionally dealt with minor changes in corporate tax policy that yielded mixed findings (Auerbach, 2002). In the United States, the Tax Reform Act of 1986 had mixed results because the maximum statutory tax rate decreased from 46% in 1986 to 34% after 1988, but simultaneous changes in several tax rules raised the fraction 2
of corporate income taxable at the maximum rate (Gordon and MacKie-Mason, 1990). In developed European countries, corporate tax reforms have occurred, albeit either gradually (e.g., France after 1985) or with policy reversions, which complicate the study of a tax effect (e.g., in 2001, Italy substantially reversed the corporate tax reforms of 1997). Similarly, the wave of flattax reforms in Eastern Europe in the context of tax competition with the aim to boost economic growth and foreign direct investment is difficult to evaluate in terms of firms’ capital structure choice since these corporate tax changes happened either too recently to evaluate (e.g., Slovakia in 2004, Romania in 2005) or simultaneously with dramatic overhauls of the personal taxation systems (e.g., Estonia, Latvia and Lithuania in the 1990s).

_Second_ , since the literature on tax effects on capital structure deals with listed firms in developed countries, it is worth investigating whether the same results apply to SMEs in transition economies. Smaller private firms have higher bankruptcy costs and face different agency problems than publicly listed firms, thus influencing debt capacity and the ability to increase equity (Ang, 1992). At the same time, in transition economies the banking sector is often the sole avenue for external finance since alternative external financing mechanisms are underdeveloped.

_Third_ , the 2001 tax reform in Croatia extended little to personal taxation, thus making it easier to identify a corporate tax effect on firm financing.<sup>1</sup> Although a number of special allowances and separate schedules were announced for certain groups of taxpayers (Urban, 2006), the aggregate amount of personal tax relief in constant prices remained roughly the same during the 2001-2004 period (Bratic, 2006). Also, except for the highest income quintile, the changes in the standard tax schedule did not affect the actual average personal tax rate (Bratic, 2006). Moreover, despite a change in dividend taxation (i.e., before the reform, dividends and shares in profit were tax exempt, while after the reform they were taxed at the rate of 15 percent), it is unclear whether this change affected entrepreneurs’ decision to receive income in the form

> 1 The tax advantage of debt is increasing in the corporate tax rate and decreasing in the personal tax rate (Miller, 1977). This is because, at the personal level, interest income is taxed at a rate that is typically higher than the tax rate on returns from common stock, essentially reducing the corporate tax benefits of debt. Thus, holding personal taxation constant, the effect from corporate tax rate reform would be unambiguous.

3
of salary rather than dividends, given that the corresponding tax brackets of the personal income taxation were equal or higher compared to the dividend tax (i.e. 15%-25%-35% versus 15%).<sup>2</sup> _Fourth_ , the elimination of the ‘Allowance for Corporate Equity’ (ACE) scheme in 2001 does not adversely affect our results. On the contrary, since the ACE allows neutrality between finance by debt and finance by equity (Devereux and Sorensen, 2005; Keen and King, 2002), the elimination of ACE would create a debt-bias, typical of standard tax systems, thus allowing a stronger test of the corporate tax reform’s positive effect on the equity choice of Croatian firms. Another important issue is that the elimination of the ACE after 2001 did not broaden the tax base substantially; Klemm (2007) suggests that there is weak evidence that ACE in Croatia had an effect on tax revenues, while in Keen and King’s (2002) review of Croatia’s tax system, it is reported that 86.3% of the population of profitable firms in 1998 was subject to taxation after estimating the profit tax base with ACE. This could be attributed to the fact that the imputed rate on the equity under the ACE scheme was equal to 5 percent plus the inflation rate of industrial product prices, a rate that was deemed as rather low by many tax experts in Croatia (Svaljek, 2005), since the protective interest rate should ideally be equal to the interest rate on risk-free investments which is difficult to estimate in the absence of developed capital markets in Croatia in the 1990s.<sup>3</sup> _Fifth_ , Croatia’s banking system quickly recovered after the brief crisis of 1998, resulting in increased credit availability and decreased loan rates that enhanced the access and use of debt by firms (Kraft, 2000). In particular, the ratio of private credit to GDP increased from 38% in 1998 to 54% in 2004, while bank long-term loan rates for enterprises decreased from 14.5% in 1998 to 6% in 2004.<sup>4</sup> Also, the rapid development of the capital markets in Croatia provided equity capital to listed firms, thus easing bank-based financing for non-listed firms, which are the sole focus of this study. In this context of substantial financial developments, a possible decrease in the debt levels of Croatian firms would strengthen our argument of a negative effect on debt financing due to the corporate tax reform. Furthermore **,** it is easier to investigate the effect of taxation changes in private Croatian companies because they did not have the size,

> 2 Similarly, the introduction of the dividend tax does not necessarily lead corporations to finance their activities largely through retained earnings (Poterba and Summers, 1985; Zodrow, 1991). 3 Keen and Kling (2002) acknowledge this criticism, but suggest that the rate was about right (namely “not too high, not too low”).

> 4 _Sources_ : World Bank, Croatian National Bank

4
organizational structure, or the global activity to receive cross-border finance, all of which would make them subject to alternative tax rules.<sup>5</sup>

# **III. DATA AND EMPIRICAL METHODOLOGY**

We focus on the non-financial private sector in Croatia, using a sample of private (non-listed), unconsolidated, non-state-owned Croatian firms from the B _v_ D Amadeus dataset (version: Jan. 2005). The data includes all formal-sector (registered) firms and was collected by _Creditreform Croatia_ , which reports that the data in Amadeus covers about 33% of the private sector (the remainder is mostly informal firms). Amadeus’ full coverage of Croatian firms begins in 1997. We create an unbalanced panel for 1998, 1999, 2002 and 2003, thus covering a period of two years before and after the corporate tax reform in 2001. We do not consider 2001 because firms may not have changed their capital structure in the first year of the reform due to the transaction time that is needed to issue new equity or debt.<sup>6</sup> The period between 1998 and 2003 provides a unique window of opportunity to study the effect of corporate taxation in Croatia; before 1997 Croatia had a higher corporate tax rate, while after 2004 there were some further changes in dividend and personal taxation.<sup>7</sup> We start with a sample of 71,748 firm/year observations for years 1998, 1999, 2002 and 2003. First, we drop 3,678 observations of financial firms, state-owned enterprises, publiclytraded firms, firms with consolidated statements, and firms operating in Free Trade Zones.<sup>8</sup> Next, we drop 1,737 observations of firms with incomplete financial data.<sup>9</sup> We next exclude

> 5 In contrast, large multinationals and dual-resident companies are typically engaging in cross-border tax arbitrage in order to take advantage of differences in corporate income tax rules between countries when double-taxation is absent. This extends to financing, where specific types of financing (e.g. international corporate bonds, currency swaps, hybrid instruments that have characteristics of both equity and debt) are sourced from countries with favourable tax conditions. 6 Notably, the findings in this paper are robust to the inclusion of years 2000 and 2001.

> 7 The new _Corporate Income Tax Act (NN No. 177/04)_ was voted in late 2004 and was effective from January 1st, 2005. Further changes in corporate taxation were introduced in 2005 and 2006 (i.e., _NN No. 90/05_ and _NN No. 57/06_ ).

> 8 Based on Croatia’s Law on Free Zones (NN 44/96 and later NN 92/05), companies in Free Trade Zones enjoy special tax treatment. The initial Amadeus sample contained 233 firm-year observations from private companies operating in Free Trade Zones. Also, since 96.9% of the companies in our sample are micro and small firms (see footnote 12), it is highly unlikely that these firms could have utilized tax incentives included in the Investment Incentives Law (NN No. 73/00), which offered tax reductions for firms that made investments of over €1.5 million and created at least ten new jobs linked to that particular investment.

> 9 We can safely assume that the observations with missing data are random, given that t-tests between these firms and the firms in the final sample reveal no significant differences in the dependent and independent variables.

5
43,824 observations with zero or less than 2 percent long-term debt to assets ratio since they represent special cases of firms that may not have access to long-term financing (typical of small infant firms or firms in remote post-conflict locations in transition countries), and as a result cannot be expected to reduce their debt levels as a result of the corporate tax reform.<sup>10</sup> Finally, since tax benefits of debt exist only for profitable firms, the sample excludes 8,460 observations of firms that registered losses.11 Our final sample includes 14,049 firm-year observations. This sample of private Croatian companies reflects mostly micro and small firms (according to the EU definition of SMEs), which account for the great majority of the sample.<sup>12</sup> Notably, in the robustness checks we include the 52,284 firms with registered losses or with ‘LT Debt-to-Assets’ ratio of less than 2 percent – and both the significance and the sign of the findings from the reduced sample of 14,049 remain unchanged with the wider sample of 66,333 firms.

The central hypothesis tested in this paper is that capital structure choices change after a reduction in corporate taxes, _ceteris paribus_ , due to decreasing tax shield benefits on earnings. In particular, based on the trade-off theory of debt, a decrease in corporate taxes reduces the optimal debt level. Moreover, this relation is expected to be stronger in smaller firms (due to arbitrage opportunities between personal and business taxation as well as higher bankruptcy probability compared to larger firms) and more profitable firms (because they are in better position to repay their existing debt and use retained earnings as marginal source of funding for investments).

In order to capture the effect of statutory tax change on capital structure, we utilize the accounting-based effective tax rate (ETR) –the ratio of income tax expense to pretax financial accounting income– which has been widely utilized in the taxation literature (Buijink et al., 2002; Callihan, 1994; Omer et al., 1991; Shackelford and Shevlin, 2001; Shevlin, 1999). Unlike the economic-theory-based effective tax rates, this accounting-based ETR reflects the

> 10 Despite the arbitrary nature of the 2 percent cutoff rate, the results are robust to alternative cutoff rates (e.g., 5%, 10%). Importantly, our results are robust to the inclusion of these observations, but the magnitude of the effect is lower.

> 11 Our results are robust to the inclusion of these observations (assuming that the effective tax rate of firms with losses is zero).

> 12 Recommendation 2003/361/EC was adopted by the EU Commission and asserted firm size classification based on either employment, sales or assets. For instance, the assets criterion divides firms into micro (less than €2m), small (between €2m and €10m), medium (between €10m and €43m) and large (over €43m). Based on this criterion, the unbalanced panel employed in this research contains 83.6% micro, 13.3% small, 2.7% medium and 0.4% large firms.

6
complexities of the tax system since it is based on the actual source of finance and asset structure of individual firms and accounts for the fact that some firms cannot always make use of all their allowances against tax (Chennels and Griffith, 1997), thus providing a measurement for actual overall tax burden of Croatian firms. Although the accounting-based ETR is firm-specific, it does reflect the tax burden changes across the entire corporate sector since the aggregate ETR approximates the statutory tax rate. As shown in Figure 1, the ETR –on average– approximates the statutory tax rate (35% and 20% before and after the reform, respectively) and small variations can be attributed to a variety of tax deductions/credits pertinent to specific incentives, accelerated depreciation, tax loss carry provisions, and tax penalties imposed by the tax authority, among other reasons.

With respect to the empirical methodology, we apply the following panel-data specification with firm fixed-effects: effects, _X_ is a vector of control variables, _ETR_ is the accounting-based effective tax rate, and ε denotes the residuals.<sup>13</sup> Regarding control variables, we utilize a series of variables that have been found previously to influence financing decisions (i.e., non-tax explanations of capital structure). Firm size, in terms of the _natural logarithm of total sales_ , captures the differences in informational costs and ex ante costs of financial distress (Bancel and Mittoo, 2004; Graham, 2000; Klapper et al., 2002). The ratio of _‘fixed assets to total assets’_ influences the cost of debt due to collateral considerations since banks tackle moral hazard and adverse selection by seeking collateral (Graham, 2000; Stiglitz and Weiss, 1981), especially in transition countries where banks

> 13 We interchangeably utilize long-term debt and equity as dependent variables, since Amadeus does not clearly indicate short-term debt (i.e., variable ‘ _Loans’_ under the category ‘ _Current liabilities’_ uniformly contains missing observations) for Croatian firms. Nevertheless, these two dependent variables are sufficient to identify an effect of taxation reform on capital structure, since long-term debt is highly correlated with short-term debt, and the level of equity reflects nondebt liabilities with tax-relief capacity. Notably, in the case of the Croatian private firms included in the BvD Amadeus dataset, “ _Non-current liabilities_ ” with “ _Long-term debt_ ” could be considered equivalent, since the observations for “ _Other non-current liabilities_ ” appear either zero or missing.

7
increasingly rely on hard information from financial statements rather than soft data gathered over time through relationship lending (Haas et al., 2007). Following Graham (2000), we use _return on assets_ and _current ratio_ as measures of cash flows and liquidity, respectively, which have a crucial effect on firm borrowing since firms with poor cash flows and liquidity are in higher need of debt. At the same time, firms with higher profitability can use retained profits thus relying less on external finance. Table 1 presents the summary statistics for the aforementioned independent variables used in the estimations. In order to capture firm-specific costs of financial distress as well as managerial entrenchment, we introduce _firm-specific effects_ (MacKie-Mason, 1990, Jensen, 1986). Moreover, with firm fixed-effects we effectively account for product market and industry considerations, which could influence firm capital structure due to industry concentration (Chevalier, 1995; Phillips, 1995), dependence on intangible or specialized assets (Rajan and Zingales, 1995; Titman and Wessels, 1988), location, and volatility of cash flows (Graham, 2000). Finally, year dummies are included in order to control for different economic cycles or other systemic changes.

# **IV. ANALYSIS OF RESULTS**

Table 2 reports the estimation results. The effective tax rate ( _ETR_ ) is positive and significant, both as a standalone and as an interaction term with the firm size, thus indicating that the tax reform in Croatia had a significant effect on firms’ capital structure. Moreover, it is found that the effect of corporate tax reform is declining with firm size. Separate estimations for four size quartiles of firms (based on total assets) show that the effect is stronger and highly significant for firms in the two smallest categories, but becomes weaker and insignificant for the two larger categories. Larger firms seem to be less sensitive to the tax reform because they enjoy more tax exemptions, deductions and allowances (Kesner-Skreb et al., 2001), as well as regressive compliance costs due to corporate taxation (Blazic, 2004). The declining effect of taxation reform in larger firms is also confirmed by the positive and significant coefficient for the interaction between _ETR_ and firm size. Also, as expected, the positive and significant effect from the interaction between _ETR_ and accounting performance illustrates that after the tax reform the more profitable firms were particularly keen to reduce their debt levels.

The control variables also offer interesting findings. In line with theoretical predictions, firm performance, as measured by return on assets, has a negative effect on long-term debt. This 8
negative relation indicates that firms fund internally using retained earnings. Also, the size, liquidity and portion of fixed assets in a firm are positively related to levels of long-term debt to assets since larger firms have more need for debt, while firms with higher liquidity and collateral capacity have easier access to debt.

In order to further substantiate the results, we repeat estimation [1] using ⎛⎜ _Equity_ ⎞⎟ as the ⎝ _Assets_ ⎠ dependent variable.<sup>14</sup> This specification is equivalent to using total liabilities to assets, which is a broader measure of borrowing, incorporating nondebt liabilities with tax-relief capacity and shortterm debt. The results, presented in Table 3, illustrate a negative and significant relation between ETR and equity levels, meaning that equity levels increased after the corporate tax reform in 2001, particularly in smaller firms and more profitable firms.<sup>15</sup> In sum, Tables 2 and 3 provide strong support that indeed equity (and not short-term debt or any other form of liability) increased and long-term debt decreased in private Croatian firms as a result of the corporate tax reform in 2001.

In addition, as we pointed out in Section III, we repeat the estimations including in the sample firms with negative performance (Table 4: Columns 1 and 3), as well as firms with ‘LT Debt-to-Assets’ ratio of less than 2 percent (Table 4: Columns 2 and 4). These companies were excluded from the initial estimations. Despite the dramatic increase of the sample, the sign and the significance of the findings remain the same, thus demonstrating the apparent effect of corporate tax reform on the Debt/Equity ratio of Croatian firms. Finally, our results are robust to:

- replacing the ETR variable with a lagged ETR variable to address possible forward timing of financing decisions (MacKie-Mason, 1990);

- performing alternative estimation methodologies such as quantile regression (see Appendix 1), and OLS with differences across the 2001 reform, such as Δ(X _t_ -X _t-3_ );

> 14 _Equity_ is equivalent to the ‘ _Total shareholders funds_ ’ variable in B _v_ D Amadeus and is the sum of capital stock, additional paid-in capital, reserves, retained earnings and premiums. It is verified that the ‘ _Total shareholders funds_ ’ variable is equal to the difference between ‘ _Total Assets_ ’ and ‘ _Total Liabilities_ ’.

> 15 This increase in equity is particularly strong for additional paid-in capital, reserves, and retained earnings. This can be illustrated with separate estimations having ‘ _Other shareholders funds_ ’ variable (from B _v_ D Amadeus) as a dependent variable. ‘ _Other shareholders funds_ ’ is the sum of additional paid-in capital, reserves, retained earnings and premiums. Results available upon request.

9
- utilizing alternative samples, such as a balanced panel to avoid attrition (see Appendix 2), or an unbalanced panel that includes observations from years 2000 and 2001.

# **V. CONCLUSIONS**

Utilizing Croatia’s corporate tax reform in 2001 as a natural experiment, this study suggests a significant effect of corporate taxation on capital structure by demonstrating that lower taxes in Croatia resulted in lower firm leverage. Overall, the corporate tax reform in Croatia provides strong evidence for a tax effect on firms’ financing policy. These findings are consistent with the trade-off theory of capital structure, which suggests that lower taxes decrease the incentive to hold debt due to decreasing interest tax deductibility. Notably, the current study focuses on the sign and the significance of the effect from tax reform without making any further claims on the magnitude of the change in debt/equity ratios, because the firm- and time-varying adjustment speed of capital structures complicates the exact identification and economic interpretation of a magnitude (Nivorozhkin, 2005).

From a policy perspective, it could be argued that the reduction in corporate debt after the corporate tax reform could have impacted firms’ access to finance. Just like other transition economies, Croatia has a bank-based financial system where low levels of debt financing are typically a supply-side phenomenon given the preferential bank financing towards state-owned enterprises and large firms. By reducing the optimal debt level, the tax reform may have - indirectly- enhanced SMEs’ access to finance. This was important since access to finance was one of the major obstacles for Croatian firms. More specifically, based on surveys from the European Bank of Reconstruction and Development (EBRD), the portion of private SMEs in Croatia that reported obtaining financing from banks as a major obstacle in their operations was reduced from 48% in 1999 to 28% in 2005.<sup>16</sup> Besides access to finance, the observed postreform reduction in the average of debt loading for the average SME may also have contributed to lowering the probability for default on its debt. In fact, from 2000 to 2004, the bank ‘nonperforming loans to total loans’ ratio in Croatia’s banking sector was steadily reduced from 9.5% to 4.6%.17

> 16 Source: EBRD - Business Environment and Enterprise Performance Survey (BEEPS) for 1999 and 2005.

> 17 Source: IMF - Global Financial Stability Report (2005).

10
The findings are also important from a policy perspective since they originate from SMEs at a time when the SME sector is a fast-growing and highly leveraged segment in transition European countries. Moreover, the finding that Croatian firms substantially increased their equity portion in their capital structure in the years immediately after the corporate tax reform indicates a speedy adjustment toward target financial leverage. Similarly, the statistically significant interactions between the effective tax rate and firm size/performance illustrate that firm-specific effects may also affect the rate of adjustment and explain the variation across firms (Flannery and Rangan, 2006).

This paper belongs to the growing empirical literature utilizing exogenous policy changes in firms’ environment in order to examine the trade-off theory of debt,<sup>18</sup> thus responding to Myers’ (1984: p. 588) challenge during his presidential address to the American Finance Association in 1984, in which he stated, “I know of no study clearly demonstrating that a firm’s tax status has predictable, material effects on its debt policy.” The findings in this study promote the potential for innovative research on corporate taxation in transition economies, such as whether corporate tax reforms affect the long-run demand for capital and firms’ investment patterns.

> 18 See Frank and Goyal (2008) for review of this literature.

11