Forex

Our marginal benefit curves are derived as in Graham (2000). Each point on these benefit
functions measures the present value tax benefit of a dollar of interest deduction. To
illustrate, ignore for this paragraph dynamic features of the tax code such as tax loss
carryforwards and carrybacks and other complexities. The first point on the tax benefit
function measures the tax savings associated with deducting the first dollar of interest.
Additional points on the function measure the tax savings from deducting a second dollar of
interest, a third dollar, and so on. Based on the current statutory federal tax schedule, each
of these initial interest deductions would be worth $0.35 for a profitable firm, where 0.35 is
the corporate marginal income tax rate. At some point, as incremental interest deductions
are added, all taxable income would be shielded by interest deductions, and incremental
deductions would be worthless. Therefore, ignoring the complexities of the tax code, a static
tax benefit function would be a step function that has an initial value of 0.35 and eventually
drops to 0.0.
The dynamic and complex features of the tax code have a tendency to stretch out and
smooth the benefit function. First, consider dynamic features such as tax loss carryforwards.
At the point at which all current taxable income is shielded by current interest deductions,
an extra dollar of interest leads to a loss today, which is carried forward to shield profits
in future years. For example, for a loss firm that will soon become profitable, an extra
dollar of interest today effectively shields income next year, and saves the firm $0.35 one
year from today. In this situation, the present value tax savings from an incremental
dollar of interest today is worth the present value of $0.35 today, or about $0.33. Once
carryforwards are considered, therefore, rather than stepping straight down to zero at the
point of surplus interest deductions, the benefit function slopes downward, reaching zero
gradually. Other features of the tax code that we consider, such as tax loss carrybacks, the
alternative minimum tax, and investment tax credits also smooth the tax benefit function
(see Graham and Smith, 1999, for details).