The influence of interest on net equity and interest rates on tax neutrality – a case study of the Brazilian corporate taxation

In this paper we visit the capital income taxation in Brazil to know whether and to what extent interest on net equity (INE) has an influence on tax neutrality, i.e., if it helps reducing debt financing advantage over equity. The paper also addresses the persistent Brazilian high interest rates influence on the cost of capital, especially for small and medium enterprises (SME), given that big companies are usually allowed to access low interest rates from BNDES, the National Public Development Bank in Brazil. Based on King and Fullerton methodology for computation of effective tax rates, this paper derives the pre-tax and post-tax rates of return on investment, the tax wedges and the correspondent effective tax rates in Brazil, comparing three sources of finance (debt, retained earnings and new equity) and three types of assets: machinery, buildings and inventories. Our simulations show that INE reduces the cost of capital for new equity by 40% but it cannot offset the debt advantage. On the other hand, very high interest rates as found in Brazil make debt finance the worst option, forcing SME to finance themselves.