Faculty Guest Post: Beauty is in the Eye of the Beholder

The last two decades have witnessed steady increases in tax avoidance activities in corporate America. A recent report in The Economist indicates that estimates of money stashed away using tax havens are around $20 trillion. Accordingly, corporate tax avoidance has received considerable attention from both academics and policy makers.

Why do some firms actively engage in tax avoidance activities while others do not (which is called the “under-sheltering puzzle”)? Traditional theory views tax avoidance as a value-added activity that transfers wealth from the government to shareholders. However, more recent studies find that tax avoidance practices incur significant direct costs (e.g., costs involving tax planning, litigation, and IRS penalties) and indirect costs (e.g., agency and reputational costs).

Do all stakeholders benefit from corporate tax avoidance? In one of my recent research works (forthcoming in the Journal of Financial Economics), I explore how debt holders perceive corporate tax avoidance. Unlike shareholders, debt holders have asymmetric payoffs. They generally receive fixed future income and face substantial downside risk. Although tax savings might accrue to shareholders, they do not necessarily benefit debt holders who are fixed claimants. For debt holders, the specter of risk exposure associated with tax avoidance could be more salient than the concomitant reward such as tax savings.

My study finds that there is a positive relation between tax avoidance and bank loan spread. In addition, banks impose more stringent collateral and covenant requirements in loans issued to firms exhibiting greater tax avoidance. Furthermore, firms with greater tax avoidance incur higher yield spreads when issuing public bonds. My study provides fresh evidence that add to a further understanding of the economic consequences of corporate tax avoidance.

Qiang Wu is an assistant professor at the Rensselaer Lally School of Management.