The Role of Creditor Protection in Lending and Tax Avoidance

Whether firms trade off debt and non-debt tax shields to reduce the tax burden is a central question in economics, finance, and accounting. Trade-off models suggest that non-debt tax shields could substitute for interest expense, thereby diluting the tax benefit associated with debt. Previous literature has found that firms use less debt when engaging in tax sheltering, suggesting that non-debt tax shields, such as tax avoidance, could substitute for debt tax shields. This evidence, however, abstracts away from any legal dimension that could affect the trade-off between debt and non-debt tax shields. In our paper, ‘The Role of Creditor Protection in Lending and Tax Avoidance’, we examine whether legal institutions empowering creditors encourage firms to substitute corporate tax avoidance with debt financing, and how the interaction between creditor protection laws and tax laws affects the incentives to substitute tax avoidance with debt.

From a theoretical perspective, the effect of creditor rights on debt financing and tax avoidance is ambiguous. On the one hand, the law and finance literature (ie, the supply-side view) suggests that, when lenders can more easily force repayment, grab collateral, or even gain control of the firm, they are more willing to extend credit, which, in turn, increases the debt capacity of firms. Hence, firms are expected to substitute non-debt tax shields, such as tax avoidance, with debt tax shields to reduce the tax burden when creditor rights are stronger. On the other hand, the demand-side view suggests that stronger creditor power against defaulting debtors has a negative effect on firms’ use of debt. This line of research argues that strong creditor protection deters managers and shareholders from using debt because of excess liquidation risk and the fear of losing control upon default. Hence, firms are expected to use fewer debt tax shields to reduce the tax burden when creditor protection is stronger.

To answer our research question, we exploit multiple bankruptcy reforms that led to changes in the strength of creditor rights in Italy over the period 2003–2011. We use these reforms because they were generally unrelated to the business cycle or other macroeconomic trends. Moreover, although creditors have the same rights to resort to a bankruptcy court in the event of default, the enforcement of a debt contract varies significantly within Italy. Crucially, though, these differences across provinces in the efficiency of bankruptcy courts do not reflect the North–South division that is typical of Italy but are related to the administration of justice, which is centralized and independent of the legislative power.

We thus take advantage of these features and proceed in two steps. First, we follow the methodology of La Porta et al. (1998) and construct a creditor rights index for Italy, which is continuous and increasing in creditor protection. Second, consistent with the efficiency of bankruptcy courts shaping the ex-ante availability of credit within the country, we partition the sample into firms with high and low debt enforcement based on the number of bankruptcy proceedings days in each province within the same region in 2003. Hence, we compare the debt and tax avoidance responses around the bankruptcy reforms of firms facing the same local economic conditions but exposed to different levels of debt enforcement.

We find that firms in provinces with strong debt enforcement increase their debt ratios relative to firms in provinces with low debt enforcement when creditor rights are stronger. We also find that firms in provinces with strong debt enforcement have higher effective tax rates. Taken together, these results are in line with the supply-side view and suggest that, when creditor rights are stronger, firms in provinces with strong debt enforcement substitute away from tax avoidance toward debt financing.

We then generalize these results by exploiting changes in creditor rights across 33 countries staggered in time from 2004 to 2013. In this cross-country analysis, we continue to find that firms take on more debt and reduce tax avoidance when creditor rights become stronger, consistent with firms trading off debt and non-debt tax shields.

Finally, we study the interaction between creditor rights laws and tax laws and find that the decision to substitute tax avoidance with debt is the result of the incentives provided by both creditor protection laws and tax laws. Firms located in countries where the tax code provides alternative non-debt tax shields, the tax enforcement is weaker, or the statutory corporate tax rate is lower have fewer incentives to increase debt and to reduce tax avoidance when creditor protection is stronger.

Altogether, our findings highlight interdependences among country legal institutions. While strengthening creditor protection appears to have a deterring effect on tax avoidance, unilateral changes in creditor rights might still not yield the desired outcome of curbing tax avoidance if not combined with an analysis of tax system characteristics. The key message is that creditor protection laws and tax laws cannot be considered in isolation, and that these laws can be less effective if they do not consider all the institutional factors that affect capital structure choices and corporate tax decisions.

Antonio De Vito is Assistant Professor of Accounting & Management Control at IE Business School, Spain

Martin Jacob is Professor and Chair of Finance, Accounting and Taxation at Otto Beisheim School of Management, Germany