In 2005 the Belgian government introduced a radically new measure into the corporate tax system: the notional interest deduction. This feature allows Belgian companies to deduct a fictitious interest cost on equity from their tax base and tackles the classical tax discrimination between debt and equity financing. We investigate whether changes in the debt ratios of Belgian small and medium-sized enterprises reflect changes in tax incentives induced by the notional interest deduction, up to three years after its introduction. To measure the tax incentives of the notional interest deduction, we incorporate the notional interest deduction into a simulation procedure of marginal tax rates. We find that (1) the notional interest deduction caused a significant decline in the average simulated marginal tax rates and (2) the change in simulated marginal tax rates due to the introduction of the notional interest deduction is significant in explaining the change in debt ratios.
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