Tax benefits of debt
In the context of corporate finance, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt than with equity. Under a majority of taxation systems around the world, and until recently under the United States tax system[citation needed], firms are taxed on their profits and individuals are taxed on their personal income.
For example, a firm that earns $100 in profits in the United States would have to pay around $30 in taxes. If it then distributes these profits to its owners as dividends, then the owners in turn pay taxes on this income, say $20 on the $70 of dividends. The $100 of profits turned into $50 of investor income.
If, instead the firm finances with debt, then, assuming the firm owes $100 of interest to investors, its profits are now 0. Investors now pay taxes on their interest income, say $30. This implies for $100 of profits before taxes, investors got $70.[1]
This tax-related encouragement of debt financing has not gone uncriticized.[2] For example, some critics have argued that the cost of equity should also be deductible; which could reduce the Internal Revenue Code's influence on capital-structure decisions, potentially reducing the economic instability attributable to excessive debt financing.[2]