Taxation and Financial Leverage in Emerging Markets: Insights from Pakistan’s Karachi Stock Exchange-100

This study set out to investigate the impact of Effective Tax Rate on Financial Leverage with a moderating role of Institutional Investor in emerging economy, like Pakistan. Using Modigliani and Miller theory or Trade-Off theory, this study highlights the importance of Financial Leverage with respect to Effective Tax Rate and Institutional Investor in the context of Pakistan, where information asymmetry and concentrated ownership patterns are prevalent. To investigate this, we have used secondary data from the financial statements of the top 50 non-financial listed firms on the Karachi Stock Exchange -100 index for the period 2016 to 2022. Using the Generalized Method of Moments (GMM), the findings suggest that Financial Leverage is positively related to Effective Tax Rate. Our findings indicate that higher tax rates encourage firms to use more debt in their capital structure to maximize tax benefits because interest paid on debt is tax deductible. Interestingly, our findings further reveal that Institutional Investor negatively moderates this relationship. This suggests that institutional investors could enhance firm monitoring by encouraging firms to use lower levels of debt, thereby reducing the costs associated with financial distress. This study provides practical implications for corporate managers, policymakers, and institutional investors. Corporate managers can make more informed financial decisions about the appropriate level of debt in their capital structure, particularly in achieving the optimal balance between debt and equity. Policymakers can develop policies that promote long-term growth and financial stability by considering the influence of institutional investors, while investors can enhance their investment strategies in developing economies.