The effect of taxes on the pricing of defaultable debt

Kian Guan Lim, Fenghua Song and Mitch Warachka

Journal of Risk

Abstract: ABSTRACT Empirical studies have documented the dependence of corporate credit spreads on default risk, equity premiums, and taxes. However, taxes have previously not been incorporated into reduced-form credit risk models. Therefore, we first extend the existing literature by considering a default intensity that depends on taxes as well as the default-free short rate and a market index. Consequently, we establish a theoretical basis to explain previous empirical findings regarding the significant impact of taxation on defaultable bond prices. Unlike previous models, tax implications for defaultable debt cannot be constructed from a sum of tax effects on zero coupon bonds. Our empirical tests then illustrate the importance of taxation. In particular, the impact of taxation increases as a function of the debt’s maturity and coupon rate.

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