Interest deductibility under default risk and the unfavorable tax treatment of investment costs: A simple explanation

In this article we focus on consumption-based taxation, which in principle requires the full deduction of both investment costs and interest expenses. Applying a real-option model, we show that debt financing induces firms to invest earlier in order to benefit from interest deductibility. Therefore, allowing partial deduction of capital cost is a necessary condition for investment neutrality. (c) 2006 Elsevier B.V. All rights reserved.