Financial Constraints and the Incentive for Tax Planning

In this study, we investigate the association between financial constraints, at both the macroeconomic and firm-specific level, and one potentially significant source of internal funds available to firms – cash savings generated through tax planning. In equilibrium a firm will undertake tax avoidance strategies if the marginal benefit (i.e., reduction in taxes payable) exceeds the marginal costs. Assuming the cost of implementing tax avoidance strategies does not increase for financially constrained firms, this suggests that firms will increase tax avoidance as access to external funds becomes more costly. Measuring financial constraints based on both macroeconomic measures (change in GDP and bank lending tightening) and firm-specific measures (a financial distress indicator based on the Altman Z-score and the decile ranking of the Whited and Wu 2006 financial constraint index), we find that firms facing financial constraints exhibit lower cash effective tax rates. Understanding how financial constraints affect tax avoidance and the interplay between macroeconomic forces and firm-level tax avoidance behavior is important as legislators look for ways to reduce the federal deficit