Do Financing Constraints Lead to Incremental Tax Planning? Evidence from the Pension Protection Act of 2006

Whether firms facing greater financing constraints turn to tax strategies that generate lower cash effective tax rates (ETRs) to mitigate the adverse effect of these financing constraints remains an empirical question of interest. We use the Pension Protection Act of 2006 (PPA 2006) as an exogenous shock to financing constraints for pension firms, but not for other firms. Using a difference-in-difference research design, we find that pension firms experience a decrease in their cash effective tax rates by 1.8 to 2.4 percent after the PPA 2006, relative to other firms. These cash tax savings mitigate the investment shortfall brought about by financing constraints by 19 percent. Our paper sheds light on the direction, causality, and economic magnitude of the association between financing constraints and tax planning activities and provides insight into the role of tax planning activities within firms’ broader corporate business strategies in responding to financing constraints.