Personal taxes, endogenous default, and corporate bond yield spreads

Term structure models have often been criticized for failing to explain satisfactorily the yield spread between corporate and Treasury bonds. A potential problem is that the personal tax effect is ignored in these models. In this paper, we employ a structural model to investigate the role of personal taxes on both debt and equity returns in capital structure decisions and assess their impact on corporate bond yield spreads. It is shown that personal taxes affect the firm's optimal capital structure, and the tax premium explains a substantial portion of yield spreads, especially for high-grade bonds. The predictive ability of the model for yield spreads is much improved when personal tax effects are accounted for. In controlling for the liquidity effect, we obtain implied personal income tax rates closely in line with Graham's estimates.