Political Connections, Financial Constraints, and Corporate Taxation

We argue that political connections help financially constrained firms access external financing and consequently reduce their incentives to use tax planning as a source of internal financing. Consistent with this argument, we find that after a plausibly exogenous increase in political connections arising from close congressional elections, although financially unconstrained firms increase their tax planning, constrained firms decrease it. The decrease in tax planning is more pronounced when the connected politicians serve on the banking-related committees. Constrained firms also experience significant decreases in costs of equity capital, bank loan spreads, and bond yields and receive more government contracts after obtaining more political connections, supporting the idea that alleviating firms’ financial constraints is the mechanism through which political connections affect the tax planning of constrained firms. Collectively, our paper highlights the importance of financial constraints in understanding the tax planning of politically connected firms.