The Effect of Tax Risk and Tax Avoidance on Credit Rating and Cost of Debt
Asian Tax Journal Vol. 20 No. 2 (2019), pp. 163-204
Abstract
This paper empirically investigate the impact of tax risk on the credit ratings or cost of debt. For the purpose of comparison, we also investigate the effect of corporate tax avoidance on the credit ratings or cost of debt. Specifically, we examine whether higher levels of tax risk or tax avoidance are associated with increased firm risk, as perceived by capital market participants (i.e., credit rating agencies as well as creditors). Recent studies in the tax literature suggests that tax risk is an important construct, and a few studies have introduced potential academic tax uncertainty or tax risk measures. These studies examine the association between tax risk and firm risk(e.g., Hutchens and Rego 2015；Kim and Ko 2016；Guenther et al. 2017；Drake et al. 2017；Kang et al. 2017 etc.). For example, Hutchens and Rego (2015) and Guenther et al. (2017) examine the positively association between tax risk (i.e., as measured by cash ETR volatility) and current and future stock return volatility as measure of firm risk. Also, in prior study examining whether investors view increased tax risk as value－increasing or value－decreasing, these results finds that tax risk are negatively associated with firm value (e.g., Kim and Ko 2016；Drake et al. 2017). However, these studies investigate only investors side. Tax risk is increasing in tax uncertainty, this is, tax－related uncertainties include uncertainty in the application of tax law to company facts, the likelihood of audit by tax authorities, uncertainty in the financial accounting for income taxes and also the quality of the accounting information on which tax decisions are based. Taken together, these tax－related uncertainties can impose substantial costs on firms, both in current and future time periods. But the extent to which credit rating agencies and creditors measure and evaluate a firm’s exposure to tax risk is not well understood. Meanwhile, corporate tax avoidance activities could induce higher uncertainty about the magnitude and volatility of the firm’s future profits and cash flows. Kim and Cho (2012), Shevlin et al. (2013), Hasan et al. (2016) find firms that avoid more income taxes have higher debt costs. Given the asymmetric payoffs of creditors, the authors conclude that creditors view tax avoidance more negatively than equity investors. Taken together, these studies provide evidence that greater corporate tax avoidance leads to higher debt costs, and higher future cash taxes paid. For analysis, following Hutchens and Rego (2015), Guenther et al. (2017), and Kang et al. (2017) we use the volatility of annual both cash effective tax rates and GAAP effective tax rates over the five prior years t－4 to t as a proxy for tax risk (hereafter TAXRISK). Following Dyreng et al. (2008), we compute cash (GAAP) effective tax rate measure over a long－run period, as the sum of cash taxes paid (tax expense) during years t－4 to t divided by the sum of pre－tax incomes during years t－4 to t. Then, tax avoidance (hereafter TAXAVOID) is (－1) times the cash (GAAP) effective tax rate of a firm in period t. Consistent with Park and Yoon (2013), we use firm’s credit ratings estimated by credit rating agencies, and we use the average interest rates and yield spread of interest rates as proxies for the cost of debt. Our sample of observations covers KOSPI and KOSDAQ listed firms based on the test variable from 2003 to 2015 (based on the dependent variable from 2004 to 2016), thus we use 7,319 firm－year observations in Korean Stock Exchange Market. Briefly, our results reveal the following. First, after controlling for several factors that affect credit ratings, we find that a significantly negative association between credit raring and tax risk, consistent with our predictions. Moreover, after controlling for several factors that affect the cost of debt, we also find that a significantly positive association between the cost of debt and tax risk, consistent with our expected. These result implies that firms with higher tax risk have lower credit ratings as well as creditors demand a higher risk premium, then credit rating agencies and creditors perceive increased tax risk as increase in firm risk (i.e., credit risk). Second, we find that a significantly negative association between credit raring and tax avoidance, consistent with our predictions. While we find that a significantly negative association between the cost of debt and tax avoidance, inconsistent with our predictions. However, this result is relatively large annual cash savings from tax avoidance potentially improve the solvency of the firm and reduce its default risk (e.g., Shevlin et al. 2013). Thus, firms pursuing more corporate tax avoidance should receive lower yields spread on bank lenders assess as the traditional viewpoints instead of the agency perspective differently on the credit rating agencies. We add to prior literature by documenting how tax risk as well as tax avoidance is viewed by credit rating agencies and creditors, especially creditors with often conflicting incentives from shareholders and with a focus on downside risk protection given their capped payoffs. An expanding literature has analyzed the consequences of tax risk in capital markets focusing mainly on equity pricing (e.g., Hutchens and Rego 2015；Kim and Ko 2016；Guenther et al. 2017； Drake et al. 2017 etc.). Therefore, our results add to this research by examining the association between tax risk or tax avoidance and credit ratings as well as cost of debt and investigating the determinants of this association.
Keywords
- Tax risk
- Tax avoidance
- ETR volatility
- Long－run effective tax rates
- Credit ratings
- Cost of debt
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