Financial Market Development and Firm Investment in Tax Avoidance: Evidence from Credit Default Swap Market

56 Pages Posted: 7 Sep 2019

See all articles by Hyun A. Hong

Hyun A. Hong

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business

Ji Woo Ryou

University of Texas Rio Grande Valley (UTRGV) (Formerly University of Texas-Pan American)

Date Written: August 30, 2019

Abstract

Lenders reduce their monitoring efforts after hedging their credit risk exposure through credit default swap (CDS) contracts, which are akin to insurance against borrowers’ adverse credit events. In this study, we examine whether, upon observing the reduced lender monitoring following CDS trading, shareholders demand that borrowing firms invest in more aggressive tax planning strategies, which were previously constrained by risk-averse lenders. Using a difference-in-differences design that exploits the variation in timing of the inception of CDS trading, we document that borrowers exhibit greater tax avoidance after the inception of CDS trading. Consistent with shareholders stepping up their demands post-CDS, we find that the increase in tax avoidance is stronger for (i) firms with more powerful and influential shareholders, as measured by dedicated institutional investors, (ii) firms with stronger shareholder defenders, as measured by board independence and board size, and (iii) firms with more strategic default options. We also find that borrowers with higher levels of tax avoidance are less likely to file for bankruptcy in the future. Our findings are robust to a battery of sensitivity checks, including controlling for cost of debt and endogeneity, as well as using alternative measures of tax avoidance.

Keywords: credit default swap, investment, tax avoidance, agency conflicts

JEL Classification: G00, G3, G33

Suggested Citation

Hong, Hyun A. and Lobo, Gerald J. and Ryou, Ji Woo, Financial Market Development and Firm Investment in Tax Avoidance: Evidence from Credit Default Swap Market (August 30, 2019). Journal of Banking and Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3445521 or http://dx.doi.org/10.2139/ssrn.3445521

Hyun A. Hong (Contact Author)

University of California, Riverside (UCR) - A. Gary Anderson Graduate School of Management ( email )

Riverside, CA 92521
United States

Gerald J. Lobo

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States
713-743-4838 (Phone)
713-743-4828 (Fax)

HOME PAGE: http://www.bauer.uh.edu/acct/acctprofile.asp?search=Gerald%20Lobo

Ji Woo Ryou

University of Texas Rio Grande Valley (UTRGV) (Formerly University of Texas-Pan American) ( email )

1201 W. University Dr.
BUSA 220
Edinburg, TX 78539
United States
956-665-8073 (Phone)

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