Corporate Tax Avoidance, Debt Ratio, and Corporate Governance: Evidence from Japan

Abstract

This study examines whether tax avoidance is associated with corporate debt policy. Specifically, this study investigates the influence of bond investors and financial institutions such as the banks, which are long-term loan owners, on corporate governance (CG) to determine comprehensively the relationship between tax avoidance and debt ratio. Note that, the financial institutions in Japan have a larger role in indirect finance policies, relative to in the European and U.S. financial markets, and that the financial institutions of the other Asian nations seem to take on the same level of responsibility as those of Japan.

This study firstly investigates the association between debt ratio and corporate tax avoidance. Secondly, we examine the influence of effectiveness of debt governance on debt ratio and CG. Thirdly, we focus on the representative tools, such as outside directors and auditors for CG and corporate tax avoidance. Finally, we test the influence of the main banks on this effect because, in addition to their monitoring role, main banks also play a significant advisory role and are thus likely to be in a better position to make superior decisions about a firm's optimal debt and capital structure mix.

According to the main result of this study, it seems that the debt enhancement effect is more dominant than the debt substitution effect in Japanese firms. When tax avoidance increases, firms’ profitability rise. Thus, considering the ability to afford a loan from a financial institution, the firms can borrow more. With regard to interactive effects among CG, debt policy, and tax avoidance, we find the CG of firms strengthens when they carry out tax avoidance. If the outside director ratio increases, then the monitoring function of the debtholders improves due to the enhancement of CG functions, and our result suggests that the financial institutions in Japan achieve an effective monitoring function.

Keywords: debt ratio, tax avoidance, debt substitution effect, debt enhancement effect, outside directors’ ratio, corporate governance

JEL Classification: M40, M48