Are Tax Avoidance Costs and Benefits Easily Quantified? Evidence from Credit Rating Disagreement

Abstract

This study investigates the role of tax avoidance in the credit rating process and whether differences exist in how rating agencies account for the risk relevance of tax avoidance. Using a sample of initial credit ratings assigned to public debt issuances during the 1994-2013 period, our evidence is consistent with credit rating agencies assessing the costs and benefits associated with tax avoidance differently, resulting in more frequent and pronounced rating agency disagreement. Rating agency disagreement over tax avoidance is most prominent when it is accompanied by relatively high levels of uncertain tax positions, foreign activities, or research and development activities, as well as lower quality tax footnote disclosures. We also find evidence that changes in tax avoidance (tax footnote disclosures) are negatively (positively) associated with the convergence of split ratings, suggesting that firms can exacerbate or mitigate rating agency disagreement subsequent to bond issuance. Our study complements prior research by examining why sophisticated information intermediaries disagree about the risk relevance of tax avoidance and sheds light on how firms can impact rating agencies’ understanding of tax avoidance.