Tax avoidance and underleverage puzzle: Korean evidence

Abstract

This paper examines whether tax avoidance substitutes for the use of debt, as well as investigating the impact of the tax-exhaustion effect and the cost of debt in this relationship. Applying a modified version of the tax-avoidance measure in Desai and Dharmapala (Rev Econ Stat 91:537-546, 2006), I determine the marginal substitution effect of tax avoidance for the use of debt for a large sample of Korean firms, generalizing the evidence of Graham and Tucker (J Financ Econ 81:563-594, 2006). Furthermore, I find that the debt-substitution effect increases with the probability of losing tax shields, suggesting that the tax-exhaustion effect interacts with the debt-substitution effect. In addition, the debt-substitution effect becomes stronger when the cost of debt is high, indicating that the cost of debt is a determinant of the substitution effect. The debt-substitution effects of tax avoidance suggest that tax-avoidance activities could offer a partial explanation for the underleverage puzzle.

Tax avoidance, cost of debt and shareholder activism: Evidence from Korea

“…These results were consistent with the results of Graham and Tucker (2006). If tax avoidance is a substitute for the use of debt (Graham and Tucker, 2006;Lim, 2010), it could increase financial slack, reduce expected bankruptcy costs, enhance credit quality, lower default risk, and therefore reduce the cost of debt.…”

“…This supports the trade-off hypothesis that the debt-substitution effect of tax avoidance would reduce the cost of debt, an issue not investigated in Graham and Tucker (2006) and Lim (2010).…”

“…The cost of the debt of a firm is determined by the characteristics of the firm and those of the bond issue that affect default risk, agency costs, and the information asymmetry problem (Bhojraj and Sengupta, 2003). Graham and Tucker (2006) and Lim (2010) suggest that tax-favored activities, such as tax shelters and tax avoidance, are a substitute for the use of debt. Graham and Tucker (2006) examine 44 tax shelter cases that were issued as a Notice of Deficiency by the Internal Revenue Services (IRS).…”

“…These cases indicate that firms use less debt when they engage in tax sheltering. Using the tax avoidance measure modified from Desai and Dharmapala (2006), Lim (2010) determines the existence of a substitution effect of tax avoidance for the use of debt for a large sample of Korean firms. These results were consistent with the results of Graham and Tucker (2006).…”

“…First, this paper makes significant contribution to previous literature by investigating the relationship between tax avoidance and cost of debt and further applying the agency perspective to the relationship. To my knowledge, this is the first attempt to explicitly examine the impact of tax avoidance on the pricing of corporate debt, which also provides some insight into the bond market reaction to the substitution effect of tax avoidance for the use of debt (Graham and Tucker, 2006;Lim, 2010). Also, this paper considers agency costs for the analysis of corporate tax avoidance on the cost of debt and investigates whether institutional investors, as shareholder activists, alleviate managerial opportunism and affect the negative relationship between tax avoidance and the cost of debt.…”