Financial Security Issuance and Cash Savings through Tax Planning

Abstract

In this paper, we investigate how firms’ issuance of equity and debt securities are associated with cash savings through tax planning. According to the pecking order theory of Myers and Majluf (1984), due to higher cost of capital attributed to information asymmetry, firms use the least costly financial resources, such as cash on hand followed by debt issuance and equity issuance to carry out investments. However, the literature on pecking order theory has not considered cash savings through risky tax planning. Since issuance of shares is the most costly and the last resort for raising capital, and issuance of debt is less costly and signals firms’ profitability, we predict that firms that issue shares will save more cash via aggressive tax planning than firms that issue debt, which are not expected to engage in as much aggressive tax planning.

Using a sample of U.S. publicly listed firms for the period 1987-2016, we find that an increase in share issuance is associated with a decrease in cash effective tax rate (CASH-ETR), indicating that firms that issue shares save cash by tax planning. We do not find any evidence that debt issuance reduces CASH-ETR or induce tax avoidance behavior. Our findings are robust when we use first difference estimation method, propensity score matching, and gross equity and debt issuances as explanatory variables, instead of net equity and debt issuances. This study provides insights into the interplay between the taxing authority and shareholders, especially when firms raise external capital.