Tax Avoidance and Debt Covenant Violation Across the Life Cycle Stages of a Firm

Abstract

This chapter focuses on the effect of tax avoidance on debt covenant violation likelihood, discussing its potential implications across the life cycle stages of a firm. The violation of debt covenants represents a relevant and costly event within the corporate capital structure management. Prior literature suggests that firms may use tax avoidance to avoid or delay covenant violation, providing two competing predictions. According to certain studies, tax avoidance is not associated with agency conflicts and can reduce debt covenant violation likelihood, increasing the expected level of after-tax cash flows. Conversely, other studies suggest that tax avoidance is associated with agency conflicts, rent-extraction by managers, and poor financial reporting quality, thus increasing the likelihood of a violation. Drawing on the Agency Theory and the life cycle literature, this chapter provides a theoretical reconciliation of these two predictions by exploring the role of corporate life cycle stages. Extant life cycle literature suggests that each stage of a firm’s development trajectory is featured by a specific cash flow pattern, different prospects of growth, and a distinct degree of alignment of interests between the managers and the shareholders, which can determine, in turn, a higher (lower) managers’ discretion in the employment of corporate resources. This chapter, thus, argues that how tax avoidance impacts the probability of debt covenant violation is likely to be contingent on the firm’s life cycle stage.