Fixed and Variable Tax Expense and the Cost of Equity Capital

Abstract

ABSTRACT Prior studies provide mixed evidence on the relation between tax avoidance and cost of equity capital. To understand how this relation varies across firms, we model income tax as containing both a fixed component (like a tax credit or deduction) and a variable component (a tax rate) and investigate how each type of tax expense affects the cost of equity capital. Unlike other fixed costs, the fixed tax component may be negative (a tax benefit). A lower fixed tax component always reduces cost of capital. The effect of a lower tax rate depends on the sign of the fixed tax component. With a negative fixed tax component, a lower tax rate increases cost of capital. Results of empirical tests are generally consistent with our predictions. Our results suggest the relation between cost of equity capital and tax avoidance is ambiguous when tax avoidance is accomplished through a lower tax rate. JEL Classifications: G12.