The role of Creditor Protection in Lending and Tax Avoidance

Published in: Journal of Financial and Quantitative Analysis

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The question of whether companies strategically balance between debt and non-debt tax shields to minimize their tax obligations is a crucial topic in the fields of economics, finance, and accounting.

Trade-off models propose that non-debt tax shields could be used as substitutes for interest expenses, diminishing the tax advantage associated with debt. Previous research has indicated that firms tend to employ less debt when tax sheltering, suggesting that non-debt tax shields, such as tax avoidance strategies, might replace debt-related tax shields.

However, these findings have overlooked the influence of legal factors that could impact the trade-off between debt and non-debt tax shields.

In our paper, we investigate whether legal institutions that empower creditors encourage firms to substitute corporate tax avoidance with debt financing and how the interplay between creditor protection laws and tax laws affects the incentives to substitute tax avoidance with debt.

The effect of creditor rights on debt financing and tax avoidance is theoretically ambiguous.

On the one hand, the law and finance literature, which represents the supply-side view, suggests that when lenders possess a greater ability to enforce repayment, seize the collateral, or assume control over a firm, they are more willing to extend credit, thereby increasing a firm's capacity for debt. Consequently, firms are expected to replace non-debt tax shields, such as tax avoidance, with debt-related tax shields to reduce their tax burden when creditor rights are stronger.

On the other hand, the demand-side view proposes that stronger creditor power over debt defaulters has a negative impact on firms' utilization of debt. This line of research argues that strong creditor protection deters managers and shareholders from resorting to debt due to heightened liquidation risk and concerns about losing control in case of default. Therefore, when creditor protection is stronger, firms are expected to utilize fewer debt-related tax shields to minimize their tax burden.

To address our research question, we leverage multiple bankruptcy reforms that altered the strength of creditor rights in Italy between 2003 and 2011. We selected these reforms because they were generally unrelated to the business cycle or other macroeconomic trends. Furthermore, although creditors possessed the same rights to initiate bankruptcy proceedings in case of default, the enforcement of debt contracts varied significantly across different regions of Italy. Importantly, these differences in the efficiency of bankruptcy courts were not aligned with the typical North-South regional divide in Italy but stemmed from variations in the administration of justice, which was centralized and independent of legislative power.

We capitalize on these distinctive characteristics and adopt a two-step approach.

First, we follow the methodology of La Porta et al. (1998) to construct a continuous and increasing creditor rights index for Italy, which captures the degree of creditor protection.

Second, by considering the efficiency of bankruptcy courts as a determinant of the ex-ante credit availability within the country, we categorize our sample into firms subject to high and low debt enforcement based on the number of days of bankruptcy proceedings in each province within the same region in 2003. This allows us to compare the debt and tax avoidance responses surrounding the bankruptcy reforms among firms facing similar local economic conditions but exposed to different levels of debt enforcement.

Our findings reveal that firms in provinces with high debt enforcement increase their debt ratios relative to firms in provinces with low debt enforcement when creditor rights are stronger. Additionally, we observe that firms in provinces with high debt enforcement exhibit higher effective tax rates. These results align with the supply-side view and suggest that when creditor rights are stronger, firms in provinces with high debt enforcement tend to shift from tax avoidance strategies toward debt financing.

We further generalize these findings by examining changes in creditor rights across 33 countries from 2004 to 2013. In this cross-country analysis, we consistently find that firms use more debt and reduce tax avoidance when creditor rights are strengthened, supporting the notion of firms balancing debt and non-debt tax shields.

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

Overall, our findings highlight the interconnectedness of legal institutions. While strengthening creditor protection seems to discourage tax avoidance, unilateral changes in creditor rights might not achieve the desired outcome of reducing tax avoidance without analyzing tax system characteristics. The key message is that creditor protection and tax laws cannot be considered in isolation, and the effectiveness of these laws can be compromised if they fail to account for all the institutional factors that influence capital structure choices and corporate tax decisions.

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Authors at the Department of Management

Antonio De Vito, Senior Assistant Professor

Academic disciplines: Accounting 

Teaching areas: Accounting & Taxation

Research fields: Empirical Tax Research, Capital Markets, Corporate Governance. 

Antonio joined the Alma Mater Università di Bologna in 2022. Before moving back to Italy, he was an Assistant Professor of Accounting at the IE Business School, IE University (Spain). As an Assistant Professor, he taught several accounting and taxation courses, both at the undergraduate and graduate levels, and won many teaching awards. Before becoming an Assistant Professor, he studied in Germany and received a Doctorate degree in Business and Economics from WHU–Otto Beisheim School of Management. His research has been published in top academic journals, presented at international conferences, and featured in various news outlets.