Debt and creative destruction: Why could subsidizing corporate debt be optimal?

Zhiguo He, Gregor Matvos

Research output: Contribution to journalArticlepeer-review

7 Scopus citations


The existing theoretical literature provides little justification for a corporate debt subsidy. We illustrate the welfare benefit of this subsidy and study how the social costs and benefits change with the duration of industry distress. In our model, two firms engage in socially wasteful competition for survival in a declining industry. Firms differ on two dimensions: exogenous productivity and endogenously chosen amount of debt financing, resulting in a two-dimensional war of attrition. Debt financing increases incentives to exit, which, although costly for the firm, is socially beneficial. These benefits 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 conflict of interest between debt and equity regarding firm liquidation.

Original languageEnglish (US)
Pages (from-to)303-325
Number of pages23
JournalManagement Science
Issue number2
StatePublished - Feb 2016


  • Capital structure
  • Debt tax shield
  • Endogenous types
  • Externality
  • Tax policy
  • War of attrition with asymmetric information

ASJC Scopus subject areas

  • Strategy and Management
  • Management Science and Operations Research


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