Corporate Taxes, Strategic Default, and the Cost of Debt

Abstract

The current U.S. tax code’s loss carry provisions provide implicit tax subsidies to financially troubled firms. Since shareholders ultimately decide when to announce bankruptcy, such tax subsidies can incentivize them to strategically postpone default. Therefore, corporate taxation can influence corporate cost of debt. Using a large panel of corporate bonds, we find supporting evidence: credit spreads become smaller as tax loss carries grow larger. In contrast, tax shields such as depreciation, which limit loss carry gains, lead to wider spreads. Interestingly, when stockholders hold greater bargaining power ― due to large managerial ownership ― larger corporate tax shields lead to even narrower credit spreads.

Keywords: Corporate tax, Credit spreads, Endogenous bankruptcy, Strategic default

JEL Classification: G11, G12, G13