Abstract
We examine the impact of aggregate tax policy uncertainty on firm-level default risk. Due to uncertainties associated with tax policies, firms could have difficulties in determining their optimal debt level and use too much debt to increase their values. This can increase firms’ financial risk and default probabilities. At the same time, tax policy uncertainty may lead some firms to take less risk which could lower their use of debt and in turn lower the probability of default. We find that tax policy uncertainty is positively associated with firms’ expected default probabilities. In terms of economic significance, our findings show an increase of 14.83% in expected default probability, on a relative basis. Our results are robust to controlling for conditions of the economy, conditions of the stock market, financial constraints of firms, and credit quality of firms. Our evidence adds to two strands of research: research on taxation and firms’ risk profiles and the impact of policy uncertainty on firms’ decisions.
Highlights
How does uncertainty associated with tax policies affect firms’ risk profiles? The existing literature examines this question by focusing on firm-level tax policies
We find a positive association between aggregate tax policy uncertainty and the firms’ default risk
We show that our findings hold after controlling for conditions of the economy, conditions of the stock market, financial constraints of firms, and credit quality of firms
Summary
How does uncertainty associated with tax policies affect firms’ risk profiles? The existing literature examines this question by focusing on firm-level tax policies. While the relation between firm-level tax policies and the firm’s risk has been studied from different perspectives, the impact of uncertainty associated with systematic tax policies on the firm’s risk has received less attention. Using a sample of 9888 U.S firms from 1987 to 2018, we document that aggregate tax policy uncertainty (TPU) is positively associated with the firm’s default risk (EDF). Our results indicate that tax policy uncertainty is positively associated with default risk regardless of the firms’ credit quality and having a bond rating or not. While the existing literature documents significant relations between firm-level tax policies and the firms’ risk (Kim et al 2011; Rego and Wilson 2012; Guenther et al 2017; Jalan et al 2016), our study shows that aggregate tax policy uncertainty affects the firms’ risk profile through default risk. Our findings show that tax policy uncertainty affects firms’ default risk
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