Taxes, Default Risk, and Yield Spreads

This paper represents an extension and integration of recent empirical and theoretical research on default risk and taxability. The purpose of the paper is to develop and test a model of interest rate spreads which incorporates both the effect of taxes and differences in default probabilities in a theoretically correct manner. There is an important fundamental difference between our approach to explaining yield spreads and the approach most commonly taken in literature. Unlike nearly all of the previous work, we do not begin with a yield spread model, i.e.,one which begins by examining differences in yields, but rather begin with an expected return or pricing model, which can then be expressed in the yield spread format. This is a fundamental difference in approaches which we feel leads to a superior theoretical formulation which can then be tested empirically without many of the problems inherent in the alter-native approach. The theoretical model is a simple extension of earlierwork on default by Bierman and Hass (1975) and Yawitz (1977), altered appropriately to take explicit account of tax effects. While there is a considerable literature that analyzes the effect of taxability on rate spreads, we are unaware of any previous study that considers tax consequences in the event of default, a rather surprising omission.