Does the Onset of CDS Trading Increase Tax Avoidance?

Abstract

Credit default swaps (CDS), provide protection against borrowers’ adverse credit events, potentially reducing lenders’ incentives to diligently monitor their creditors. In this study, we examine whether this reduction in lender monitoring induces greater corporate tax avoidance by borrowers. Using a difference-in-differences approach that exploits the variation in dates of the onset of CDS trading, we document that borrowers exhibit greater tax avoidance following the onset of CDS trading. Additionally, we find the observed effect to be stronger when lenders’ reputation costs in the event of a borrower default are lower. The effect is also more pronounced when ex-ante shareholder-manager agency conflicts are greater, suggesting that increased post-CDS tax avoidance is likely an outcome of managerial rent extraction as opposed to asset substitution. Additional analyses reveal that the observed effect is stronger for firms that are informationally opaque and financially constrained. Our study provides the first evidence on a potentially unintended effect of CDS trade initiation on corporate tax policies.