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A Note on Firms' Investment Under Tax Benefits of Debt and Exogenous Debt Constraint

This paper questions the idea that the deduction of debt interest is always a good policy instrument in order to spur investment. Particularly, it analyzes the investment choice in a "financing hierarchy" framework with an exogenous constraint on the amount of the debt that the firm can contract. We show that if the interest rate on debt is decreasing in the capital accumulation and it is available another financial resource (as equity) more expensive than debt (at least for initial levels of debt), then the deduction of debt interest from taxes on capital income may reduce the firm's investment.This theoretical contribution should be considered when financial intermediaries are not willing to finance beyond a fixed threshold but firms have access to the stock market.