Political Connections, Financial Constraints, and Corporate Taxation

Abstract

We argue that the greater tax planning of politically connected firms documented in prior literature depends critically on firms' financial conditions, because political connections help financially constrained firms access external financing and consequently reduce their incentives to use tax planning as a source of internal financing. We find that after a plausibly exogenous increase in political connections, although financially unconstrained firms increase their tax planning, constrained firms decrease it. Moreover, constrained firms are more likely to obtain new external debt financing and their costs of debt are also lower after increased political connections. Importantly, the decreases in tax planning are more pronounced for constrained firms with new external debt, and when the connected politicians serve on the banking-related committees. Taken together, our paper highlights the importance of financial constraints in understanding the tax planning of politically connected firms.

Keywords: Political connections, corporate tax planning, financial constraints, external financing