Do Tax Holidays Increase Expectations of Future Tax Holidays: An Examination of Debt Issuances Pre- and Post-AJCA

• In Event: Tax, History, and Historical Tax

Abstract

We examine the relation between a firm’s level of permanently reinvested earnings and its likelihood to issue debt to fund its investments and operations. Pecking order theory predicts that firms will use internal funds over external funds, if internal funds are present. Permanently reinvested earnings are a subset of a firm’s internal funds. Financial accounting rules allow firms to include these foreign earnings on their financial statements as earned without recognizing the associated tax expense. Thus, firms may be inclined to accept the risk associated with debt rather than repatriate funds and bear financial reporting costs.

Using the repatriation holiday created under the 2004 American Jobs Creation Act as a partitioning event, we find that a firm’s likelihood to issue debt is significantly influenced by its level of permanently reinvested earnings, but only in the post-AJCA tax holiday period. These results suggest that (1) firms consider tax and financial reporting costs when deciding whether to issue debt or repatriate funds and (2) there is an expectation for future tax holidays on repatriations. Furthermore, the results suggest the predictions of pecking order theory may not strictly hold when financial reporting and tax rules are taken into account.

Authors

• Tripp Petzel, Virginia Tech University

• Debra A. Salbador, Virginia Tech