How Corporate Taxes Quietly Favor Carbon-Intensive Companies

Corporate taxes rarely feature in the climate-policy debate. When governments want companies to pollute less, the usual tools are carbon taxes, emissions trading systems, environmental regulation or subsidies for clean technologies. Corporate income taxation belongs to another policy world: one concerned with investment, public revenues and economic growth. But those two worlds may be more closely connected than they appear.

A study published in the American Economic Review argues that a seemingly technical feature of corporate taxation — the preferential treatment of debt — systematically benefits companies with higher carbon dioxide emissions. The result is an environmental bias hidden inside the tax code. The paper is by Luigi Iovino, (Bocconi University’s Department of Economics and IGIER research center), Julien Sauvagnat, (Bocconi’s Department of Finance and a research fellow at IGIER and BIDSA), and Thorsten Martin of the Frankfurt School of Finance and Management.

The US corporate tax code contains an implicit subsidy on CO₂ emissions.

Their starting point is that among publicly listed US companies, firms that generate more CO2 relative to their sales tend to face lower effective corporate income tax rates. As the authors put it, “the US corporate tax code contains an implicit subsidy on CO₂ emissions.”

The hidden climate effect of corporate debt

The explanation does not begin with environmental regulation. It begins with a factory, a machine and a bank loan. Carbon-intensive industries tend to depend heavily on tangible assets such as machinery and equipment. Those assets, in turn, can obviously be pledged as collateral. A lender can assess their value and, if necessary, repossess them. Companies with more tangible capital can therefore generally sustain more debt.

That matters because interest payments on corporate debt are deductible from taxable income, while payments to shareholders are not treated in the same way. Debt therefore creates what economists call a debt tax shield: borrowing reduces the amount of corporate income exposed to taxation.

Clean firms often look different. Their value is more likely to depend on intangible assets such as knowledge, intellectual property, organizational capital and similar resources. These are much harder for lenders to value or seize, so they provide weaker collateral and support less borrowing.

The result is an unexpected chain linking balance sheets to carbon emissions: carbon-intensive production tends to require more physical equipment; physical equipment supports more borrowing; more borrowing generates larger interest deductions; and those deductions reduce effective corporate taxes.

The researchers have tested that mechanism using financial and emissions data for publicly listed US companies between 2003 and 2021. Once differences in tangible capital are considered, they report, the statistical relationship between CO₂ intensity and leverage — and between CO₂ intensity and lower effective tax rates — largely disappears.

In other words, the authors do not conclude that the tax authority explicitly gives polluting companies a special carbon break. The environmental bias emerges indirectly from the interaction between production technology, corporate borrowing and the tax treatment of interest.

The 2017 tax cut provides a test

The United States then offered the researchers something close to a natural experiment. The Tax Cuts and Jobs Act, enacted at the end of 2017, reduced the federal corporate income tax rate from 35% to 21%. If carbon-intensive firms were already benefiting more from the tax shield provided by debt, the authors reasoned, then companies with lower emissions should have more to gain from a general reduction in the statutory corporate tax rate.

After the reform, cleaner firms expanded more strongly. Depending on the specification, capital growth among CO₂-intensive companies was 7.7% to 9.7% lower relative to clean firms. The researchers subject the result to a series of tests, including checks for pre-existing trends, other provisions of the 2017 reform, industry-specific shocks and comparisons involving foreign companies not exposed to the US tax cut.

The logic can seem paradoxical at first. A lower corporate tax rate reduces taxes for everyone. But it reduces the value of interest deductions at the same time. Firms that previously benefited heavily from those deductions therefore receive a smaller relative boost than companies whose profits were more fully exposed to corporate taxation in the first place. That creates what the economists call a composition effect: economic activity shifts toward cleaner sectors.

Cutting carbon intensity is not the same as cutting emissions

Here the distinction between total emissions and emissions intensity becomes important. Using a multisector general-equilibrium model calibrated to the US economy, Iovino, Martin and Sauvagnat simulate a corporate tax reduction comparable to the 2017 reform. Lower taxes stimulate production, so total economic activity rises. That growth itself pushes emissions upward. But clean sectors grow more than dirty ones, while companies also adjust their mix of production inputs. Consequently, emissions increase much less than output does, and the economy becomes less carbon intensive.

This does not mean that ordinary corporate tax cuts are part of climate policy. Economic growth can still increase total CO₂ emissions. Rather, the study shows that corporate tax design changes who grows, and that this change in the composition of the economy can have significant environmental consequences.

What if debt lost its special tax advantage?

The authors model a reform that eliminates the debt tax shield by ending the preferential tax treatment of interest payments. Because doing so would effectively raise taxation on corporations, they combine the change with a reduction in the corporate tax rate sufficient to keep GDP essentially unchanged. In their benchmark simulation, the reform reduces total CO2 emissions by around 3.6%, with GDP held constant by design.

The mechanism again runs through the composition of production. Removing the tax advantage of debt disproportionately increases financing costs for sectors built around highly pledgeable physical capital — precisely the sectors that tend to be more carbon intensive. Cleaner sectors consequently account for a larger share of economic activity.

Real-world climate policy is rarely ideal: carbon prices are incomplete, uneven or politically difficult to implement. Under those conditions, provisions buried deep inside the corporate tax code can reinforce or counteract environmental policy. The authors argue that when political constraints prevent first-best climate policies, there may be a case for taking environmental effects into account when corporate tax rules are designed.

The point applies far beyond just deducting interest expenses. Corporate tax breaks for particular kinds of investment, depreciation rules and other provisions can change the relative cost of different forms of capital. And because different kinds of capital are associated with different production technologies, apparently non-environmental rules may ultimately affect emissions.

Climate policy does not begin and end with policies bearing a green label. The architecture of an economy, including rules written for purposes that have nothing to do with the climate, can quietly tilt investment toward one kind of production or another. And sometimes the carbon subsidy is hiding in the balance sheet.