The Effect of Tax on Capital Structure under Uncertainty: Model and Empirical Evidence Based on Prospect Theory

Based on Prospect Theory, a model about statutory tax rate and capital structure is developed and proves to be proper by regression analysis with data from 307 Chinese listed companies from 2001 to 2005. The results show that there is a significantly positive relation between tax rate and the amount of debt if the firm is in a certain circumstances in which the Cognitive Bias on the cost of financial distress(CFD) is not serious so the firm chooses the optimal capital structure determined by tax benefit and CFD, while the relation between them is not significant if the firm is in rather uncertain circumstances, in which the Cognitive Bias is very serious and firm becomes a risk taker and perceives that more debt can create more value, so he will use as much debt as possible without considering the tax benefit.