Taxes, Limited Liability and Leverage

We discuss the combined effects of tax convexity, limited liability and leverage on risk-taking. First, we focus on a risk-averse investor who is indifferent to equity-finance a risky asset in a pre-tax setting. We derive the after-tax marginal prices for risk-averse investors. Symmetric taxation causes an increase in marginal prices, while convex taxation causes a decrease. The negative effects of tax convexity can be overcome by debt-financing a risky project in the case of limited liability for the debtor. We develop explicit solutions for optimal leverage and show that tax convexity is a sufficient condition for a high degree of leverage. In contrast to previous literature, we explain why increasing tax-convexity will increase leverage. Second, we solve for the coefficient of risk-aversion, making a creditor indifferent to supplying the required debt-financing contract. The results indicate that analyzing tax effects separating investment and financing decisions is not useful in case of tax convexity