Fixing the Environmental Bias in Corporate Tax Policy

Reforming tax policies to align with climate objectives is essential for achieving sustainability. The current corporate tax framework unintentionally subsidizes polluting firms through the debt tax shield, creating a misalignment with environmental goals. Addressing this bias could reduce emissions without compromising economic activity. Our research provides a clear path toward a tax system that is both less distortive and better aligned with environmental objectives.

Corporate income tax (CIT) is a tax levied on the profits of businesses. It is a cornerstone of the US fiscal system, contributing $420 billion in 2023, or roughly 10% of total federal revenue. Despite its importance, its economic impact remains a contentious issue. Critics argue that corporate taxes deter investment, while proponents highlight how tax rates on large businesses have steadily declined over recent decades, driven by globalization and profit-shifting strategies. This decline, they contend, has exacerbated wealth inequality, as business ownership is concentrated among the wealthiest individuals.

One notable feature of the corporate tax code is the ability for firms to deduct interest payments on debt. This deduction has led to disparities in effective tax rates, potentially resulting in inefficiencies and resource misallocation. While much research has examined how corporate taxes affect investment, wages, and prices, little attention has been paid to their environmental impact. Do high-emission (“dirty”) firms pay more or less in taxes than low-emission (“clean”) firms? How do tax reforms influence environmental outcomes? Our study, conducted alongside colleagues from Bocconi University, addresses these questions for the first time.

Corporate income tax policies shape firm investment decisions, influencing the level and composition of economic activity. Our research reveals that CO2-intensive (“dirty”) firms disproportionately benefit from the debt tax shield. As a result, current tax policies unintentionally favor high-emission firms, running counter to economic principles advocating for policies that lead firms to internalize environmental costs.

The Debt Tax Shield: A Key Advantage for Dirty Firms

The debt tax shield is a key tax provision that permits firms to deduct interest payments on debt, thereby lowering their taxable income. This provision disproportionately benefits firms with significant tangible assets, such as machinery and equipment, which serve as collateral for borrowing. As a result, dirty firms can sustain higher debt levels and significantly reduce their tax liabilities and effective tax rates.

Our research shows a clear link: a one standard deviation increase in CO2 intensity corresponds to a 10% decline in effective tax rates on capital income. This tax advantage stems from the higher pledgeability of tangible assets, which makes debt financing more accessible for carbon-intensive firms.

The Relationship Between CO2 Emissions and Tax Rates

The finding that firms with higher carbon emissions tend to pay lower effective tax rates is a striking fact to uncover. CO2 intensity, measured as tons of CO2 emissions per $1,000 of output, negatively correlates with effective tax rates, calculated as corporate income taxes paid over gross capital income. This pattern suggests that the current US tax system inadvertently subsidizes pollution.

We linked CO2 emissions data from publicly listed US firms (dating back to 2003) with financial data from Standard & Poor’s Compustat. The results point to one major factor: the tax advantage provided by the deductibility of interest payments, commonly referred to as the “tax shield” of debt. Carbon-intensive firms, due to their capital-heavy nature, disproportionately benefit from this provision.

Why Dirty Firms Benefit More from the Tax Shield

Dirty firms—for instance those in manufacturing and energy—rely heavily on tangible assets like machinery and equipment. These assets serve as collateral, enabling them to secure larger loans and take on higher levels of debt compared to their cleaner counterparts. This, in turn, allows them to deduct more interest expenses, reducing the share of their income subject to taxation and lowering their effective tax rates.

Clean firms, which depend more on intangible assets like patents and software, face greater borrowing constraints and benefit less from the tax shield. This disparity creates a structural tax advantage for dirty firms, reinforcing their competitive edge over cleaner businesses.

To validate these findings, we controlled for differences in tangible capital across firms. Once these differences were accounted for, the relationship between CO2 intensity, leverage, and effective tax rates disappeared. This confirms that the tax shield’s benefits are intrinsically tied to the higher tangible capital of dirty firms.

Testing the Robustness of Our Findings

To ensure our results are reliable, we conducted several robustness tests. First, we verified that our findings were not driven by any single sector. We also tested alternative ways of measuring CO2 emissions and scaled income taxes by sales or assets instead of capital income. Finally, we explored whether these patterns held within specific industries, including the energy sector. Across all these tests, the relationship between CO2 intensity, tangible capital, and lower tax rates remained consistent, underscoring the structural nature of this tax advantage for dirty firms.

The Impact of Trump’s Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced a major reduction in the corporate tax rate, from 35% to 21%. This reform provided a unique opportunity to study how tax cuts affect different types of firms. Based on our earlier findings, we expected clean firms to benefit more from the tax cut, as a larger portion of their income is subject to taxation. Our analysis confirmed this: clean firms saw a more significant drop in their effective tax rates than dirty firms.

Using a statistical method called difference-in-differences, we found that CO2-intensive firms experienced a smaller reduction in federal income taxes relative to their gross capital income. For the most polluting firms, this translated into a 2.4 percentage point relative increase in their effective tax rates compared to clean firms. This higher tax burden had tangible consequences. The top quartile of dirty firms grew their assets 11% less than their clean counterparts after the TCJA.
These results highlight a key dynamic: tax cuts, while designed to stimulate the economy, can unintentionally promote cleaner industries. By giving a relative advantage to clean firms, the TCJA contributed to a subtle but important shift toward a less carbon-intensive economy. This underscores the broader role tax policy can play in driving environmental change.

Modeling the Environmental Impact of Tax Policy

To better understand the environmental impact of corporate tax policy, we used a general equilibrium model that links CO2 emissions to fossil fuel consumption. The model incorporates two key factors: first, industries vary in their capital intensity and carbon emissions, and second, the cost of capital are influenced by the tax shield of debt, which affects firms’ reliance on capital.

The model simulates the effects of removing the tax shield while simultaneously lowering the overall corporate tax rate to keep GDP unchanged. This change led to a 1.3% reduction in total CO2 emissions without harming economic growth. The logic is straightforward: without the tax shield, cost of capital increases, especially for dirty firms that rely more on debt to finance their operations. These firms scale back while cleaner firms expand, leading to a greener economy.

Motivated by the empirical pattern that CO2 emissions are strongly correlated with equipment, we also explored scenarios where equipment and fuel are complementary in production. In these cases, removing the tax shield had an even larger impact on reducing emissions, as firms cutting back on equipment lowers fuel consumption further.

Broader Implications for Environmental and Fiscal Policy

The environmental bias in corporate taxation has far-reaching implications. By subsidizing carbon-intensive firms through the debt tax shield, current policies inadvertently undermine efforts to combat climate change. Addressing this bias is not just a matter of lowering tax distortions; it is also a critical step toward achieving net-zero emissions.

Moreover, the interaction between tax policy and environmental outcomes highlights the importance of integrating climate considerations into fiscal reforms. Policymakers need to recognize that even ostensibly neutral tax provisions, such as the deductibility of interest payments, can have significant environmental consequences.

Our findings suggest that well-designed tax reforms can achieve multiple objectives. By removing the debt tax shield and reducing the statutory tax rate, governments can create a more level playing field for clean and dirty firms, foster economic efficiency, and reduce emissions.

Policy Recommendations

To address the environmental bias in corporate taxation, policymakers should consider the following:

Consequences of Tax Rate Changes for the Green Transition: In the presence of the debt tax shield, changes in statutory tax rates affect clean and dirty firms differently, with direct consequences for the green transition. Lowering corporate tax rates boosts clean firm investment more, thereby reducing economy-wide carbon intensity.
Limiting the Debt Tax Shield: Cap the deductibility of interest payments, particularly for carbon-intensive firms. This measure would reduce the tax advantage for such firms, encouraging a shift toward cleaner production practices.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Thorsten Martin is an associate professor of Finance at Frankfurt School of Finance & Management.