Tax provisions favoring corporate debt over equity finance (“debt bias”) are widely recognized
as a risk to financial stability. This paper explores whether and how thin-capitalization rules,
which restrict interest deductibility beyond a certain amount, affect corporate debt ratios and
mitigate financial stability risk. We find that rules targeted at related party borrowing (the
majority of today’s rules) have no significant impact on debt bias—which relates to third-party
borrowing. Also, these rules have no effect on broader indicators of firm financial distress.
Rules applying to all debt, in contrast, turn out to be effective: the presence of such a rule
reduces the debt-asset ratio in an average company by 5 percentage points; and they reduce
the probability for a firm to be in financial distress by 5 percent. Debt ratios are found to be
more responsive to thin capitalization rules in industries characterized by a high share of
This paper analyzes how differences in legal origin, judicial efficiency, and investor protection affect firm leverage and earnings volatility across developing countries. Using a large number of developing countries, four main findings are highlighted. First, firms in civil legal origin countries rely more on debt financing compared to firms in common law countries, and they exhibit lower earnings volatility. Second, under weak judicial enforcement, firms tend to borrow more but they take less risk. Third, stronger creditor rights increase debt financing and reduce earnings volatility. Fourth, firm listing on a developed stock exchange shifts the capital structure towards more equity financing, and it increases the firm’s ability to borrow more when the judicial system is inefficient. The results reinforce the importance of strengthening laws and institutions as well as deepening capital markets in developing countries to improve financing conditions and investment outcomes.