The Allowance for Corporate Equity in Europe: Latvia, Italy and Portugal

Classical corporate taxation typically favours debt finance over equity. The resulting bias leads firms to be over-leveraged. The Allowance for Corporate Equity (ACE) tries to stop such bias by granting a deduction on the cost of equity. The implementation of that principle however differs between countries. In this paper we investigate three recent ACE reforms which occurred in Latvia, Italy and Portugal respectively. Using a broad range of evaluation methods and a large dataset at firm level, we analyse the possible debt-reducing effect of an ACE. From a methodological point of view we innovate by relating the difference-in-differences (DID) method, which captures the effect of the treatment, i.e. the sole existence of an ACE, and the Effective Marginal Tax Rate (EMTR), which measures the impact of the intensity of that treatment. When we do not make a difference between, say, firm sizes, we find a decrease of the financial leverage by 1-2% for both Italy and Portugal, while the leverage increases in Latvia. Also of interest is that, though Italy and Latvia show a larger leverage cut among large firms, small firms are relatively more affected than medium-sized firms in Portugal