Tax Avoidance and Capital Structures
The effect of tax avoidance on capital structure choices
Authors : Yoojin Lee (CSULB), Terry Shevlin (UC Irvine) and Aruhn Venkat (UT Austin)
Published : Journal of the American Taxation Association (2022)
Link to Article: The effect of tax avoidance on capital structure choices
In this study, we examine the effects tax avoidance on firms’ capital structure decisions. Prior studies focus on the effects of tax avoidance on cost of equity and debt capital. These studies find varying associations between tax avoidance and cost of equity capital but generally find a negative association with cost of debt (e.g. Goh, Lee, Lim and Shevlin 2016; Hasan, Hoi, Wu and Zhang 2014). We extend this literature by focusing on a direct and important consequence of cost of capital effects: capital structure decisions.
Tax avoidance may affect financing decisions in at least two ways. First, tax avoidance may affect the relative costs of equity and debt capital. Tax avoidance may increase future expected cash flows and thereby decrease cost of equity (Goh et al. 2016) However, tax avoidance may engender increased risk which may increase both the cost of equity and debt (Hutchens and Rego 2013); Shevlin, Urcan and Vasvari 2020;) Second, tax avoidance may affect financing due to managerial biases. Survey evidence suggests managers mistakenly focus on GAAP effective tax rates rather than marginal tax rates in making financing choices (Graham, Hanlon, Shevlin and Shroff 2017). If so, managers will issue equity rather than debt as the firm increases tax avoidance because tax avoidance lowers GAAP ETRs, leading managers to (incorrectly) estimate a higher after-tax cost of debt and exhibit a bias towards equity.
Our main dependent variable captures the propensity to issue equity rather than debt. Our main independent variable is the three-year cash effective tax rate. We use several covariates known to affect tax avoidance based on prior studies. Using logistic regressions, we document positive association between tax avoidance and firms’ propensity to issue equity relative to debt after controlling for firms’ marginal tax rates. Using path analyses, we find that tax avoidance is 1) positively associated with cost of debt and 2) negatively associated with cost of debt. More importantly, we find that these effects explain the positive association between tax avoidance and the propensity to issue equity rather than debt.
Next, we use the 9th Circuit’s Xilinx decision in 2010 to mitigate endogeneity concerns. The decision invalidated regulations intended to reduce income shifting, resulting in greater tax avoidance among 9th Circuit firms. We document evidence that Ninth Circuit firms 1) increased tax avoidance following the decision relative to firms in other Circuits and 2) were more likely to issue equity rather than debt following the decision and relative to firms in other Circuits.
Finally, we turn to behavioral effects. We find evidence that one-year GAAP effective tax rates are positively associated with the propensity to issue equity relative to debt. We use an annual GAAP effective tax rate because survey evidence is consistent with managers using the annual GAAP ETR in making capital structure decisions (Graham et al. 2017). Next, we isolate managerial bias towards GAAP ETRs by controlling for permanent, discretionary tax avoidance and continue to continue to find a positive association between GAAP ETRs and the propensity to issue equity relative to debt. Overall, our study contributes to the literature on tax avoidance and cost of capital effects by documenting the way and extent to which these effects affect capital structure, an important firm outcome. Moreover, we extend the literature on tax rates and corporate finance by documenting the financing consequences of managerial focus on GAAP ETRs instead of marginal tax rates