Debt and Creative Destruction: Why Could Subsidizing Corporate Debt Be Optimal?

The existing theoretical literature provides little justi…cation for a corporate debt subsidy. We illustrate the welfare bene…t of this subsidy and study how the social costs and bene…ts change with the duration of industry distress. In our model, two …rms engage in socially wasteful competition for survival in a declining industry. Firms di¤er on two dimensions: exogenous productivity and endogenously chosen amount of debt …nancing, resulting in a two dimensional war of attrition. Debt …nancing increases incentives to exit, which, while costly for the …rm, is socially bene…cial. These bene…ts decline as industry distress shortens. Our normative model sheds light on why the debt tax subsidy still persists around the world. Analogously, the model can also rationalize a seemingly ad hoc feature of the U.S. tax system, which subsidizes the con‡ict of interest between debt and equity regarding …rm liquidation.