The Effect of Corporate Tax Strategy on Corporate Bond Yields
Asian Tax Journal Vol. 20 No. 3 (2019), pp. 105-135
Abstract
Previous studies have examined whether and how stock market participants assess corporate tax avoidance (Hanlon and Slemrod 2009；Wilson 2009；Koester 2011；Hutchens and Rego 2012；Goh et al., 2013). Some argue that tax avoidance reduces corporate tax payments and increases after－tax cash flows, so shareholders seeking to maximize firm value positively evaluate tax avoidance decisions of the firm. However, others report that shareholders view corporate tax avoidance activities negatively because firms should spend additional costs for tax strategies and potential risks for future tax investigation. Furthermore, firms also should pay for various non－tax costs such as the reduction in transparency and quality of financial reporting (Scholes et al. 2008). Most of these studies are based on equity investors, so the analysis of investors in the public debt market is very limited. As capital market participants, creditors of the firms have quite different characteristics from shareholders. Unlike shareholders who have claims on the firm value, creditors only have fixed claims on the principal and interest of the bond. Thus, two groups of investors have conflicting views on the firms’ business decisions such as investment plans. In this respect, the creditors’ evaluation on corporate tax avoidance might be different from that of the shareholders. In order to analyze creditors’ assessment of corporate tax avoidance, this study investigates the effect of corporate tax avoidance on public debt cost and its interaction effect with tax avoidance consistency. From a creditor’s point of view, corporate tax avoidance can be positively assessed if it leads to reduce firms’ default risks by increasing after－tax cash flows. On the other hand, tax avoidance activity can be negatively viewed if it increases operating risk, information asymmetry, and agency costs, resulting in greater uncertainty in future cash flows. Lim (2011) shows that tax avoidance lowers borrowing costs in Korean private debt market. On the other hand, Shevlin et al. (2013) reports that firms exhibiting greater tax avoidance tend to have higher return on corporate bonds due to the uncertainties in future cash flows. Korean bond market, in comparison with the U.S. bond market, has a greater demand for high quality corporate bonds due to investors’ concern over default after the 1997 global financial crisis. In this situation, we predict that bond investors in Korea can negatively evaluate corporate tax avoidance in hypothesis 1. The effect of corporate tax avoidance on expected cash flows and risks can be different depending on which tax strategies the firms use to lower tax burdens. When the firms engage in tax strategies consistently, the persistence of tax savings increases and the persistence of earnings also increases (Chen et al. 2012). That is, the firms’ consistent tax strategies not only generate stable after－tax cash flows, but also lowers non－tax costs such as financial reporting costs. In our hypothesis 2, we question whether bond investors consider the consistency of corporate tax avoidance in investment decisions and we predict that consistent tax avoidance mitigates the positive relationship between tax avoidance and corporate bond yields. Using firms listed on KOSPI and KOSDAQ markets from 2003 to 2011, we find a significant positive relationship between the level of tax avoidance and corporate bond spread. Given that tax avoidance increases the uncertainty of future cash flows and creates non－tax costs such as lower financial reporting quality, our result implies that bond investors negatively assess corporate tax avoidance and require higher bond offering yields on the tax avoiders. We also find that the consistency of corporate tax avoidance mitigates the positive relationship between tax avoidance and bond spread. It indicates that bond investors are less negative about the risk of the firms with consistent tax strategies than other firms with inconsistent tax strategies. We contribute prior literature as follows：First, we use corporate bond yields and analyze how public debt investors assess corporate tax avoidance using corporate bond yields. Prior studies on capital market reactions to corporate tax avoidance have focused mainly on the stock market, and studies on the reactions of the debt market are limited. Even within the creditor group, the asymmetry of profit and downside risk varies depending on whether the bonds they invest are private or public debts, so the marginal benefits and costs of tax avoidance are not homogeneous. In response, we focus on the public debt market, which has higher information asymmetry due to the lack of access to private information of the firms, and investigate the assessment of corporate bond investors on tax avoidance. Second, we extend prior literature by showing that corporate bond investors reflect the consistency of tax strategy on corporate bond spreads. In particular, our results that corporate bond spreads are different depending on how consistently corporate bond issuers keep their tax payments, suggesting that firms can lower financing costs through consistent tax strategy.
Keywords
- corporate tax avoidance
- cost of public debt
- consistency of tax avoidance
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