Debt and Taxes: The Role of Tax Avoidance

Peter Brok

♦ Empirically, the effect of corporate tax rates on leverage has been smaller than expected based on trade-off theory. In this paper, I show that tax avoidance functions as a non-debt tax shield, reducing the benefits of the debt tax shield. I find that higher tax rates cause higher non-debt tax avoidance, which crowds out the debt tax shield. This tax avoidance affects the strength of the relationship between debt and tax rates. A one standard deviation higher tax rate implies 2.8 percent higher leverage for low tax avoidance firms, but has a negative effect for high tax avoidance firms.

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