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.
Lin, K. G., Song, F., & Warachka, M. (2004). The effect of taxes on the pricing of defaultable debt. Journal of Risk, 6(2), 1-29. https://doi.org/10.21314/JOR.2004.103