Abstract:

This study is aimed at understanding the role of personal taxes in bond pricing. In particular, it answers questions such as whether default risk and personal taxes have to be jointly considered in a term structure model; if they do, what is the magnitude of the tax effect? How is the optimal capital structure affected by personal taxes directly and indirectly through their feedback into bond prices? And what is the model-implied tax rate after we account for liquidity premium and calibrate the model against the observed data? Traditional term structure models have consistently underestimated the spread of corporate bonds, and this problem of underestimation is more severe for high-grade bonds. A common feature shared by these models is that the effects of personal taxes are assumed away.

In the first part of this study, I extend the structural models with exogenously given leverage by building in personal taxes. I investigate the relative magnitudes of tax-related and default-related premiums and show that personal taxes have a significant impact on corporate bond spread. In particular, I demonstrate and offer a proof that there exists a nonlinear tax-default interaction which prevents one from treating both factors separately.

In the second part of this study, I formulate a framework to allow for leverage to be determined endogenously. It is found that personal taxes have profound impacts on many firm characteristics beside debt value, e.g., the optimal capital structure. Finally, I calibrate the model against the observed data on 10-year bonds for different ratings to compare four different structural approaches and extract the model-implied tax rates. The implied tax rates based on the extended Leland and Toft (1996) approach match the empirical value very well.