How effective is an incremental ACE in addressing the debt bias? Evidence from corporate tax returns

The Allowance for Corporate Equity (ACE) introduced in Italy in 2011 has decreased the fiscal distortion between the costs of equity and debt by introducing the deductibility from taxable income of a notional return on capital increases. In this paper, we estimate the impact of the ACE on the leverage ratio of Italian manufacturing firms. Using a novel instrumental variable approach to identify the causal effect, we find that the introduction of the incremental ACE has substantially reduced the leverage ratio of its beneficiaries. We find that the effect is larger for smaller enterprises and for mature firms. In addition, the impact of the ACE is higher for vulnerable and risky firms than for sound firms. These results suggest that an incremental ACE may be an effective policy tool to reduce the leverage ratio of European firms.