The Impact of Tax Shields on Bankruptcy Risk and Resource Allocation

Abstract

This paper studies how tax loss carryforwards affect corporate bankruptcies. Exploiting variation in tax policies across Europe and using a single-country regression discontinuity design, I show that firms are more likely to go bankrupt when stricter loss carryforward rules decrease expected future cash flows. This effect occurs predominantly within business groups, suggesting that managers reduce the support of struggling member firms through internal capital markets when stricter tax rules reduce these firms' tax loss shields. Industry-level analyses further show that the tax-subsidized survival of group firms under lenient LCF rules translates into lower aggregate productivity. The collective evidence suggests that generous tax policies can prolong firm survival but also create tax planning incentives that can impair the allocation of resources to the most productive firms. The results are particularly timely in light of the recent economic crises, in which many countries altered their tax loss rules.

Keywords: Business groups, Internal capital markets, Resource allocation, Financial distress, Losses, Corporate taxation, Productivity

JEL Classification: G32, G33, H25, M41, M48, D22, D24