Peer Benchmarking Tax Avoidance for Cost of Debt

Abstract

We show that managers can significantly lower corporate borrowing costs by adjusting effective tax rates. While prior research suggests a positive linear relation between tax avoidance and cost of debt, we document a U-shaped relation in which bondholders reward “undersheltering” firms with a decreasing cost of debt for increasing their tax avoidance until a point at which the relation reverses. As firms move toward the most aggressive tax avoidance levels, their cost of debt increases. Our study is the first we are aware of to provide evidence of a non-linear, U-shaped relation between tax avoidance and cost of debt. Additionally, we provide evidence suggesting that the range of effective tax rates corresponding to lowest borrowing costs varies greatly by industry. We show that managers can lower costs of debt (average yield savings of 1.37%) by benchmarking their firm’s tax avoidance relative to their industry peers.

Keywords: Tax Avoidance, Undersheltering, Tax Strategy, Cost of Debt

JEL Classification: G21, G32, H26