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This paper examines the capital structure puzzle that many firms appear to be are underleveraged from a tax savings perspective. The tradeoff theory of capital structure predicts that firms will borrow up to the point where the marginal value of tax shields on additional debt is just offset by the increase in the costs of financial distress. There is a general consensus that significant tax incentives are available through corporate borrowing. Nevertheless, many large and profitable companies with apparently low risk of financial distress have relatively low debt ratios. The perceived inefficiency of capital structure from a tax perspective is particularly surprising, since taxes seem to be “important” or “very important” to most of the CFOs surveyed by Graham and Harvey (2001).

Several studies have documented a negative relation between profitability and leverage, challenging the tradeoff theory, suggesting that firms do not fully exploit their tax shields and therefore, appear to be underleveraged (see, e.g., Miller (1977), Fama and French (2002) and Rajan and Zingales (1995) among others). Recently, Graham (2000) quantified the tax benefits of corporate borrowing by estimating marginal tax rates and concluded that “the firms that use debt conservatively are large, profitable, liquid, in stable industries”, and face low ex ante costs of distress. He estimates that the typical firm could add up to 15.7% (7.3%) to firm value, ignoring (considering) the personal tax penalty on debt financing.

The literature has advanced several explanations for the insufficient use of debt in capital structure. On the supply side, Faulkender and Petersen (2005) suggest that capital is is rationed by lenders and firms have a limited ability to increase leverage. On the demand side, Molina (2005) and Almeida and Philipon (2006) re-estimate the ex ante probability of distress, accounting for endogeneity and default risk premium, and find a stronger impact on leverage. Another line of research investigates whether non-debt tax shields substitute for interest deductions for corporations, as suggested by DeAngelo and Masulis (1980). Bradley, Jarell and Kim (1984) and MacKie-Mason (1990) examine the role of depreciation and tax credits. While many of the non-debt tax shields can be easily found on the income statement, many others are not disclosed at all, or at best they are hidden in footnotes (e.g. stock option deductions, tax shelters, and pension contributions).

Thus, firms that appear highly profitable on their financial statements could, in fact, have very low taxable income. Graham, Lang, and Shackelford (2004) examine NASDAQ 100 and S&P 100 firms and find that option deductions are substitutes for interest deductions in corporate capital structure decisions. Graham and Tucker (2006) investigate 44 cases of tax sheltering and find that the average tax deduction produced by the shelters is about three times as large as the interest deductions of comparable firms. In a recent working paper, Schallheim and Wells (2006) use an alternative measure for all non-debt tax deductions the tax spread and find that it is positively related to Graham’s measure of debt conservatism.

Departing from the existing literature, this paper addresses the underleverage issue by reexamining the structure of liabilities of the firm. Despite the noticeable size and high seniority of pension plan obligations, the role of corporate defined benefit pension plans is missing from the capital structure debate. The deferred compensation for employees arising from corporate pension plans constitutes another form of debt of the company. Pension contributions are tax deductible, similar to the interest payments on debt, and failure to make mandatory contributions ultimately leads to bankruptcy. Yet, most pension plan accounts are recorded off balance sheet, and a very intricate pension accounting process often obscures their importance.

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