The Price of Power: How Managerial Taxes Affect Debt Contract Provisions

Abstract

We examine how income taxes—both managerial and corporate—influence the design of firms’ debt contracts and their use of financial covenants in particular. Both levels of taxation have the potential to exacerbate conflicts of interest among creditors, shareholders, and managers and, consequently, should influence the design of their debt contracts. Specifically, a decrease in corporate and an increase in managerial taxes encourage managers to take more risk, accordingly, we predict and find that loans issued following such changes in taxation are more likely to include performance rather than capital covenants. A series of cross-sectional tests provide further insight into the effect of both levels of taxation, and corroborate our main inferences. Overall, our study demonstrates how debt contract layouts change in response to arguably exogenous changes in income taxes—and, in turn, managers’ preferences—for risk.