The Parabolic Relationship of Tax Avoidance and Cost of Public Debt

We find that, contrary to prior findings, tax avoidance has a non-linear relationship with cost of debt. Debtholders reward increasing tax avoidance with decreasing bond yields for “undersheltering” firms until reaching a minimum yield. Beyond that minimum yield, as tax avoidance increases, debtholders penalize firms with increasing costs of debt. We use secondary bond market as our empirical setting as the yields are not affected by market timing at issuance. We test several models to conclude that a quadratic function best captures the relation between tax avoidance and cost of debt. Our findings are robust to various specifications of the effective tax rate measure, to the exclusion of large firms, and in both investment grade and speculative grade subsamples.