The Impact of Thin-Capitalization Rules on External Debt Usage – A Propensity Score Matching Approach

This paper analyzes how multinational enterprises respond to a restriction on interest deductions incurred for internal borrowing. The emphasis of the study is on a firm’s response with respect to external borrowing. The empirical investigation applies propensity score matching techniques and exploits the 2001 reform of the German thin-capitalization rule to solve endogeneity problems. The results suggest that restrictions on internal debt are associated with expansions in external debt finance, indicating a substitutional relationship. Since multinational enterprises can use internal debt to shift profits from high- to low-tax countries, this finding implies that policies aimed at securing corporate tax revenue possibly fail and should be subject to careful scrutiny by policymakers.