The Impact of Tax Shields on Bankruptcy Risk and Resource Allocation

Abstract

This paper studies how tax shields from loss carryforwards affect corporate default rates and productivity. Exploiting variation in tax policy across European countries and a single-country regression discontinuity design, I show that firms are less likely to default when they have greater tax losses that provide future cash benefits. This effect occurs predominantly within business groups, which are more able to exploit tax incentives through their internal capital markets and thereby attenuate the bankruptcy risk of member firms. While generous tax loss policy aids firms in responding to economic crises, results also show that these tax shields subsidize unproductive group member firms, translating into lower aggregate productivity at the industry level. Collectively, this study sheds new light on the economic consequences of tax loss use, thereby informing policy changes that permit more generous loss utilization in light of the recent economic crisis.

Keywords: Business groups, Internal capital markets, Resource allocation, Financial distress, Losses, Corporate taxation, Productivity

JEL Classification: G32, G33, H25, M41, M48, D22, D24