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FINANCIAL ECONOMICS | RESEARCH ARTICLE
Does tax aggressiveness and cost of debt affect
firm performance? The moderating role of
political connections
Abdullah
1
*, Muhammad Arsalan Hashmi
2
, Abdul Mateen
1
, Yousuf Ali Badshah
1
and
Muhammad Sikander Iqbal
1
Abstract: Firms in emerging economies continue to suffer as a consequence of tax
evasion, high cost of financing, political interference, weak governance systems, and
bureaucratic institutions. In order to understand how these challenges complicate
commercial activities, this study examines how tax aggressiveness, cost of debt, and
political connections affect firm performance in Pakistan. Unlike previous research, we
also explore if political connections moderate the association between (i) tax aggres-
siveness and firm performance and (ii) cost of debt and firm performance. Our robust
empirical analysis reveals that tax aggressive firms have weaker performance while
politically connected firms have better performance, ceteris paribus. Further, we find
that tax aggressive firms having politically connected board members have better
performance as compared to their non-connected counterparts. Similarly, firms with
a high cost of debt and politically connected board members have better performance
as compared to non-connected firms. Thus, we argue that political connections help
connected firms in overcoming the adverse consequences of tax aggressiveness and
the high cost of debt through their influence in procuring government projects, sub-
sidies, and other benefits. Therefore, policymakers are advised to restrict politically
connected board members from extending favors and concessions to connected firms.
We also encourage shareholders to exercise their voting power and monitoring cap-
abilities for mitigating agency problems inherent in politically connected firms.
Subjects: Quantitative Finance; Statistics for Business, Finance & Economics; Education -
Social Sciences
Keywords: tax aggressiveness; cost of debt; firm performance; political connections
1. Introduction
Developing countries face a host of problems such as tax evasion (Khuong, Liem & Thu, 2020),
high cost of financing (Alvarez-Botas & Gonzalez, 2019), political interference (Faccio, 2010),
poor corporate governance (Al-ahdal et al., 2020) and institutional weaknesses (Khurshid, 2015)
which adversely affect firm performance and economic growth. Prior studies indicate that tax
aggressive behavior by managers compromises financial reporting transparency which increases
agency conflicts between the contracting parties and aggravates the information asymmetry
problem (Dyreng et al., 2016). Further, firms face increased litigation risk, higher regulatory
scrutiny, and adverse reputational consequences from engaging in tax aggressive behavior
(Cook et al., 2017; Graham et al., 2014). These adverse consequences of tax aggressiveness
increase the risk for investors, lenders, and shareholders. It has been argued that lenders are
Abdullah et al., Cogent Economics & Finance (2022), 10: 2132645
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Page 1 of 17
Received: 21 March 2022
Accepted: 02 October 2022
*Corresponding author: Abdullah,
College of Management Sciences,
Karachi Institute of Economics &
Technology
E-mail: abdiman.0688@yahoo.com
Reviewing editor:
David McMillan, University of Stirling,
UNITED KINGDOM
Additional information is available at
the end of the article
© 2022 The Author(s). This open access article is distributed under a Creative Commons
Attribution (CC-BY) 4.0 license.
reluctant to invest in firms with dubious accounting practices and high risk. Further, lenders that
are willing to provide financing to such risky firms may enforce strict debt covenants and
demand a high cost of debt. These debt covenants may restrict firms from investing in risky
projects which adversely affects firm performance. We argue that firms invest in establishing
political connections to overcome the adverse consequences of tax aggressiveness and the high
cost of debt on firm performance, especially in developing countries (Yan & Chang, 2018). Prior
studies suggest that firms exploit political linkages for procuring government projects, subsidies
and avoiding regulatory scrutiny (Faccio, 2010; Khwaja & Mian, 2005).
Tax aggressiveness and evasion have remained a serious problem in Pakistan for a long
time. According to the official statistics, Pakistan has a tax to GDP ratio of 11% which is
considerably lower as compared to several emerging economies. The Ministry of Planning,
Development and Special Initiatives has estimated that Pakistan has a shadow economy
constituting nearly 40% of GDP. This indicates that a large part of the economy remains
undocumented and does not contribute to the overall tax collection. The poor collection in
Pakistan is mainly due to a flawed tax collection mechanism, corruption, and the lack of
accountability for tax evaders. Further, the high level of corruption and lack of accountability
encourages firms to engage in tax aggressive practices. Pakistan has suffered immensely due
to the consistently low tax collection by the government over the last few decades. The low
tax collection has adversely affected the public sector development expenditure, economic
growth and contributed to high inflation in the country. Given the importance of adequate tax
revenue for the development of Pakistan, it is imperative that policymakers, academics,
industry stakeholders and the general public must make concerted efforts for wider structural
changes to the taxation system in Pakistan.
Based on the above discussion, this study analyzes the nexus between tax aggressiveness, cost
of debt, political connections, and firm performance in the context of an emerging economy i.e.
Pakistan. Emerging economies have unique features and institutional dynamics which make
them an interesting avenue for research. Pakistan is also an emerging economy with law and
order challenges (Khurshid, 2015), political interference (Hashmi, Brahmana & Lau, 2018), and
corruption (Ali et al., 2019). Further, previous studies did not provide sufficient evidence on the
nexus between tax aggressiveness, cost of debt, political connections, and firm performance in
the context of developing countries (Khuong, Liem & Thu, 2020). Thus, this study has several
research objectives. First, the study investigates the relationship between tax aggressiveness and
firm performance. Second, we examine the relationship between the cost of debt and firm
performance. Third, we analyze whether political connections moderate the association between
(i) tax aggressiveness and firm performance and (ii) cost of debt and firm performance, in the
context of Pakistan.
Our study contributes to the existing literature in several interesting and unique ways. First, we
document that tax aggressiveness and cost of debt affect firm performance in the context of
a developing country i.e. Pakistan. Second, we provide evidence that political connections moderate
the relationship between (i) tax aggressiveness and firm performance and (ii) cost of debt and firm
performance. Third, we argue that firms invest in establishing political connections to overcome the
adverse consequences of tax aggressiveness and the high cost of debt and exploit political linkages in
procuring government projects, concessions, subsidies, and other discretionary benefits.
The study is structured in the following manner. The next section provides the theoretical
background, review of influential literature, and hypotheses development. Subsequently, data
and methodology is presented. It is followed by a discussion of the results and further analysis
of the study. Lastly, the conclusion of the study is presented highlighting the key implications,
limitations, and suggestions for future research.
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2. Literature review
2.1. Theoretical background
The theoretical foundation of this study is mainly based on the agency theory. The agency theory
explains the conflict which may arise between the contracting parties i.e. the principal and agent
(Fama & Jensen, 1983). Further, this theory elaborates how governance and monitoring mechan-
isms may be used to limit the misappropriation by agents and diverging interests of contracting
parties (Jensen & Meckling, 1976). Prior literature suggests that firms suffer from severe agency
problems if they are politically connected. These agency problems are a consequence of politically
connected board members pursuing their political agenda and expropriating firms’ resources at
the expense of key stakeholders. Further, several studies document that managers usually save
resources through tax evasion and other accounting misappropriations and then use these accu-
mulated resources for furthering their private interests. This may lead to adverse reputational
consequences for a firm and compromise the shareholders’ wealth maximization objective.
2.2. Hypothesis development
2.2.1. Tax aggressiveness and firm performance
Tax aggressiveness refers to deliberate attempts by firms’ to reduce their tax obligations using
various accounting strategies (Hanlon & Heitzman, 2010). Tax aggressiveness can potentially
benefit as well as harm a firm and its stakeholders. Firms pursuing tax aggressive strategies
may have higher free cash flow resulting in improved creditworthiness, lower risk, and cost of
capital (Khuong et al., 2020). The benefits of tax aggressiveness ensue when the interests of
managers are aligned with the shareholders (Desai & Dharmapala, 2009). The agency theory
suggests that when there are conflicts of interest between managers and shareholders, managers
may expropriate excess free cash flow obtained from tax aggressiveness. Contrarily, some studies
have argued that tax aggressive firms are considered riskier by shareholders and creditors as they
may face tax audits, regulatory action, and penalties that would damage their reputation (Drake
et al., 2017; Guenther et al., 2017). Further, tax aggressive firms usually face stringent debt
covenants from lenders as they are plagued with agency conflicts and weak performance
(Hasan et al., 2014). In addition, tax aggressive firms may face a higher cost of equity as share-
holders perceive them to be less transparent having acute information asymmetry problems
(Balakrishnan et al., 2019; Goh et al., 2016).
The existing literature on tax aggressiveness and firm performance is scarce and reports
mixed results (Khuong et al., 2020; Chen et al., 2014). Several studies document a positive
association between tax aggressiveness and firm performance (Inger, 2014). These studies
argue that tax aggressiveness would benefit a firm if the tax strategy is transparent and avoids
complex business transactions. Further, it is contended that tax aggressiveness will positively
affect firm performance when a firm has superior corporate governance mechanisms (Desai &
Dharmapala, 2009). On the contrary, many studies found a negative relationship between tax
aggressiveness and firm performance (Hanlon & Slemrod, 2009; Zhang et al., 2017). The weak firm
performance is due to higher agency costs and increased information asymmetry. Tax aggressive-
ness may also lead to complicated business transactions which provide opportunities for man-
agers to expropriate excess free cash flow and undermine firm performance (Bushman et al., 2004;
Cook et al., 2017). Therefore, we can develop the following hypothesis:
H1: Tax aggressiveness is negatively associated with firm performance, ceteris paribus.
2.2.2. Cost of debt and firm performance
The influence of the cost of debt on firm performance may be analyzed using the agency theory.
The agency theory implies two different perspectives on how the cost of debt may affect firm
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performance (Jensen & Meckling, 1976; Myers, 1977). First, the theory suggests that a higher level
of debt financing and cost of debt are associated with higher agency costs that reduce firm
performance (Majumdar & Chhibber, 1999; Le & Phan, 2017). The higher agency costs may be
a direct result of conflicts of interest between shareholders and debt-holders as each is pursuing
their private interests. Second, the agency theory also asserts that firms employ debt financing for
reducing the conflicts of interests between managers and shareholders (Weill, 2008). Firms can
use debt financing to put pressure on managers to generate sufficient free cash flow for servicing
debt obligations (El-Chaarani, 2015). Moreover, the high cost of debt also reduces the likelihood of
free cash flow expropriation by managers. Therefore, the high cost of debt resulting from debt
financing tends to enhance firm performance (El-Chaarani, 2015; Jensen, 1986).
Prior studies have provided mixed results on the association between the cost of debt and
firm performance. Different authors have investigated the relationship between the cost of debt
and firm performance in various contexts. Some studies have suggested a negative association
between the cost of debt and firm performance in Vietnam (Le & Phan, 2017), Nigeria (Akeem
et al., 2014), Sweden (Yazdanfar & Ohmar, 2015), and India (Dawar, 2014; Majundar & Chhibber,
1999). Contrarily, Tsuruta (2015a) found a positive relationship between the cost of debt and firm
performance in Japan. In addition, El-Chaarani (2015) also documented a positive relationship
between the cost of debt and firm performance in several countries. Furthermore, some studies
reported mixed results between the cost of debt and firm performance in China (Dalci, 2018), the
USA (Simerly & Li, 2000), Malaysia (Salim & Yadav, 2012), Ghana (Abor, 2005) and Egypt (Ebaid,
2009). In view of the agency theory and empirical evidence, we develop the hypothesis:
H2: Cost of debt is negatively associated with firm performance, ceteris paribus.
2.2.3. Political connections and firm performance
Political connections usually arise when corporate boards comprise directors with political linkages.
The role of political connections on firm performance can be analyzed in the light of agency theory.
The agency theory suggests that politicians may expropriate minority shareholders’ wealth and
pursue objectives that may not maximize firm value. The literature suggests that politically
connected firms expropriate minority shareholders’ wealth in several ways. First, politically con-
nected board members directly entrench minority shareholders. Second, they motivate majority
shareholders to entrench minority shareholders. Third, they influence management to hire politi-
cally connected managers for pursuing their own social and political goals. Several studies suggest
that political connections will negatively affect firm performance (Fisman, 2001; Faccio, 2006; Liu
et al., 2013; Fan et al., 2007). Lemmon and Lins (2003) argue that firms with politically connected
shareholders have lower market performance as compared to non-connected firms. Jackowics
et al. (2014) found that Polish firms have shown a negative relationship between political connec-
tions and firm performance. Similarly, in the Malaysian context, Jaffar and Abdul-Shukor (2016)
document that political connections diminish firm performance and value.
On the other hand, the resource dependence theory suggests that political connections
influence the external environment and resources of a firm (Hillman, Withers & Collins, 2009).
The theory implies that firms develop linkages with political figures so that they can easily access
scarce resources held by other entities. For example, firms with political connections can easily
procure government grants, loans, and contracts. In other words, firms use political connections to
overcome external environment uncertainties. Several studies have used the resource dependence
theory to analyze the role of political connections on firm performance (Guo et al., 2014; Hillman,
2009; Bona-Sanchez et al., 2014). These studies document a positive relationship between political
connections and firm performance. Past studies suggest that political connections are more
valuable for firms operating in emerging economies (Guo et al., 2014). Su et al. (2014) argue
that firms with political connections have superior performance due to their competitive
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advantage acquired from access to intangible resources and government support. Given the
evidence from emerging economies, we hypothesize a positive effect of political connections on
firm performance.
H3: Political connections are positively associated with firm performance, ceteris paribus.
Tax aggressiveness undermines the financial reporting quality and increases agency pro-
blems within the firm (Dyreng et al., 2016). Prior studies have also argued that tax aggressive firms
suffer from adverse reputational consequences due to regulatory scrutiny and legal action by
stakeholders (Cook et al., 2017; Graham et al., 2014). As a consequence, tax aggressive firms may
face problems in raising external capital and lenders may employ stringent debt covenants which
restrict such firms from investing in risky projects. Furthermore, lenders also demand a higher cost
of debt from tax aggressive firms in order to be compensated for bearing higher risk. In view of the
adverse consequences for tax aggressive firms, we argue that these firms develop political con-
nections for exploiting political linkages and the influential status of politicians for overcoming
reputational issues and gaining convenient and cost-effective access to financing (Khwaja & Mian,
2005; Faccio, 2010; Sapienza, 2004). Thus, the presence of politicians on the board will provide
benefits to tax aggressive firms and those with a high cost of debt which will ultimately improve
firm performance. Hence, we develop the following hypotheses:
H4: Political connections moderate the association between tax aggressiveness and firm perfor-
mance, ceteris paribus.
H5: Political connections moderate the association between cost of debt and firm performance,
ceteris paribus.
3. Methodology
3.1. Data and sampling
To investigate the relationship between variables, this study used a dataset of 201 non-financial
companies listed on the Pakistan Stock Exchange for the period 2015 to 2019. This provided us
with 1005 firm-year observations for empirical analysis. We have excluded financial firms listed on
the Pakistan Stock Exchange as they have different regulatory practices and performance metrics.
The data was extracted from the annual reports of the listed firms which were available on the
companies’ websites. We have restricted our sample size to 201 non-financial firms as the dataset
was manually collected since access to a data repository was not available. Our dataset is
tremendously important for studying political expropriation and tax evasion as Pakistan provides
a unique institutional context characterized by weak rule of law, government ineffectiveness,
political interference, and high corruption.
3.2. Measurement of variables
This study investigates the relationship between political connections, tax aggressiveness, cost of
debt, and firm performance. This section provides the measurement of variables used in this study.
3.2.1. Firm performance
This study uses firm performance as a dependent variable. The firm performance was measured using
return on assets (ROA) consistent with Shaskia (2012), Yanikkaya et al. (2018), Tangngisalu et al.
(2020), Pattiruhu and Paais (2020), and Ali and Faisal (2020). ROA was calculated as a proportion of
net profit to a firm’s total assets. We chose ROA as the measure of firm performance mainly for two
reasons. First, ROA is a more widely used measure of firm performance/profitability in the finance
literature (Abdullah, Hashmi & Iqbal, 2022; Ciftci, Tatoglu, Wood, Demirbag, & Zaim, 2019; Mardnly
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et al., 2018). Second, our review of the literature indicated that several previous studies related to tax
aggressiveness and cost of debt have predominantly used ROA as the only measure of firm perfor-
mance/profitability (Lim et al., 2018; Chen, 2012; Flamini, Vola, Songini, & Gnan, 2021).
3.2.2. Key independent and moderating variables
The study uses tax aggressiveness and cost of debt as key independent variables. The literature
provides several proxies for measuring tax aggressiveness (Landry et al., 2013; Lanis &
Richardson, 2012). We have measured tax aggressiveness as a dummy variable taking a value
of 1, if a firm is tax aggressive and 0, otherwise consistent with Richardson, Taylor and Lanis
(2013) and Richardson, Taylor and Lanis (2016). A firm is considered tax aggressive if it pays
a lesser percentage of corporate taxes as compared to the corporate tax rate defined by the
government (Chen et al., 2010; Lanis & Richardson, 2012). We specify a firm to be tax aggressive
in two steps. First, we calculated the effective tax rate by dividing taxes paid with the earnings
before taxes (EBT). Second, we compared the effective tax rate with a corporate tax rate defined
by the government. Further, the cost of debt was computed as a proportion of interest expense
to a firm’s total interest-bearing debt consistent with Ha, Trang and Vuong (2022). Moreover,
the study has used political connections as an independent as well as a moderating variable.
Political connections represent a dummy variable taking a value of 1, if a firm is politically
connected and 0 otherwise (Faccio et al., 2006; Faccio, 2010; Hashmi, Brahmana & Lau, 2018).
A firm is considered politically connected if the directors on the board are either directly or
indirectly affiliated with a political party. A firm is considered to have direct political connections
when a politician is present on the board (Faccio et al., 2006). Further, indirect political connec-
tions may be developed when a board member has a close association with a political party or
politician (Faccio, 2010; Hashmi, Brahmana & Lau, 2018).
3.2.3. Control variables
In addition to independent, dependent, and moderating variables, several control variables were
also used such as firm size, leverage, and property plant & equipment in our empirical analysis.
Firm size was measured through the natural logarithm of total assets (Altaf & Shah, 2017) and
leverage was measured as a proportion of total debt to total assets (Pattiruhu & Paais, 2020).
Further, property, plant, and equipment were measured as a ratio of fixed assets to total assets of
a firm (Febriyanto & Firmansyah, 2018).
3.3. Model specifications
This section presents the model specifications used for ascertaining the relationships between the
variables. Models, 1–3 represent the baseline models which were estimated to validate H1, H2, and
H3, respectively. H1, H2, and H3 will be supported if the coefficients of tax aggressiveness
(TAXAGG), cost of debt (COD), political connections (POLC) are statistically significant, respectively.
Models 1–3 are presented below:
ROA = �
1
+�
2
TAXAGG+�
3
SIZE+�
4
LEV+�
5
PPE+∑�
i
YEAR_DUMMY+∑�
j
INDUS_DUMMY+u (1)
ROA = �
1
+�
2
COD+�
3
SIZE+�
4
LEV+�
5
PPE+∑�
i
YEAR_DUMMY+∑�
j
INDUS_DUMMY+u (2)
ROA = �
1
+�
2
POLC+�
3
SIZE+�
4
LEV+�
5
PPE+∑�
i
YEAR_DUMMY+∑�
j
INDUS_DUMMY+u (3)
Further, Models 4–5 represent the interaction models which were estimated to validate whether
POLC moderates the association between (i) TAXAGG and ROA (ii) COD and ROA. H4 and H5 will be
supported by the results if the coefficients of TAXAGG*POLC and COD*POLC, respectively are
statistically significant. Models 4 and 5 are presented below:
ROA = �
1
+�
2
POLC+�
3
TAX+�
4
TAX*POLC+�
5
SIZE+�
6
LEV+�
7
PPE+∑�
i
YEAR_DUMMY
+∑�
j
INDUS_DUMMY+u (4)
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ROA ¼�
1
+�
2
POLC þ�
3
COD þ�
4
COD �POLC þ�
5
SIZE þ�
6
LEV þ�
7
PPE þ∑�
i
YEARDUMMY þ∑�
j
INDUS_DUMMY + u (5)
3.4. Statistical analysis
The Feasible Generalized Least Squares (FGLS) technique was used to investigate the impact of
tax aggressiveness, cost of debt, political connections on firm performance. The FGLS technique
is usually used when the dataset suffers from heteroscedasticity, non-normality, heterogeneity,
time-invariant cross-sectional dependence, and serial correlation (Afonso et al., 2021; Le &
Nguyen, 2019; Kmenta, 1986; Parks, 1967). Further, we have used the Prais-Winsten Panel-
Corrected Standard Errors (PW-PCSE) technique to cross-validate our results from the FGLS
technique. Beck and Katz (1995) suggest that the PW-PCSE technique is better able to deal with
the issues of a panel dataset such as unit-level heteroscedasticity, heterogeneity, and serial
correlation. Further, this technique accounts for spherical errors and offers better inference as
compared to linear models (Bailey & Katz, 2011).
4. Results and discussion
4.1. Descriptive statistics
Table 1 presents the descriptive statistics of the variables used in this study. The results
suggest that the mean value of ROA is 3.76% (standard deviation of 11.38%). The mean value
is lower as compared to the mean values of 8.918% and 8.3% reported by Ismail (2016) and
Anser and Malik (2013), respectively for firms listed on the PSX. Further, the mean value of
POLC is 58.20% (standard deviation of 49.34%) which suggests that 58.20% of the sample
firms are politically connected. This mean value is quite higher as compared to 2.7% reported
by Kusnadi (2019) for a sample comprising of firms from developed and emerging economies.
Moreover, the mean value of TAXAGG is 0.7691 (standard deviation of 0.4215) which suggests
that 76.91% of our sample firms are tax aggressive. The mean value is higher as compared to
65% and 35% reported by Herusetya and Stefani (2020) and Dunbar, Higgins, Phillips and
Plesko, (2010) for the Indonesian and US firms, respectively. In addition, the results suggest
that the mean value of COD is 0.2762 (standard deviation of 2.5434) which implies that the
average cost of debt for our sample firms is 27.62%. The cost of debt is higher as compared to
5.4% reported by Ha, Trang and Vuong (2022) for Vietnamese firms. Lastly, Table 1 reports
mean values of 4.4372, 0.6877, and 0.6217 for SIZE, LEV, and PPET, respectively. The Shapiro-
Wilk statistics reported in Table 1 are statistically significant suggesting that the variables are
non-normally distributed. The total number of firm-year observations is 1005.
4.2. Pearson correlations
Table 2 provides the Pearson correlations of the research variables. The results suggest that
ROA has a positive and significant correlation with POLC (r = 0.2189). This indicates that
politically connected firms have better financial performance. Contrarily, we find that ROA
has a negative and significant association with TAXAGG (r = −0.1363), COD (r = −0.0096),
SIZE (r = −0.1644), LEV (r = −0.4668) and PPET (r = −0.0829). These results suggest that firms
that are tax aggressive and those having a high cost of debt usually have weak financial
performance. Similarly, firms that are large, have high leverage, and abundant property, plant,
and equipment tend to have weak financial performance. Table 2 also shows that POLC has
a negative and significant correlation with TAXAGG (r = −0.0668). Thus, we argue that politically
connected firms are usually less tax aggressive, perhaps because they face increased scrutiny
from the general public and rival politicians. Further, TAXAGG is positively and significantly
correlated with LEV (r = 0.0932) and PPET (r = 0.0628) which implies that large firms with
abundant property, plant and equipment are usually more tax aggressive. This may be because
these large firms have greater opportunities to evade taxes through creative accounting
practices.
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4.3. Panel regression results
4.3.1. Baseline regression results
The baseline panel regression results are reported in Table 3. The results suggest that TAXAGG has
a negative and statistically significant relationship with ROA in Model 1 (�= −0.0047, p < 0.01). This
implies that tax aggressive firms have lower profitability as compared to others. This result is
consistent with the agency theory and the existing literature (Khuong et al., 2020; Balakrishnan
et al., 2019). It has been argued that the tax aggressive behavior of managers usually increases
agency conflicts as managers may utilize the surplus cash to pursue their private interests (Dawar,
2014). Further, tax aggressive firms are more susceptible to regulators’ scrutiny, creditors scepti-
cism, and decline shareholders’ trust, leading to an adverse reputational risk that lowers firm
performance (Khuong et al., 2020; Drake et al., 2017; Balakrishnan et al., 2019; Goh et al., 2016;
Guenther et al., 2017; Hasan et al., 2014).
Moreover, Table 3 suggests that COD does not have a statistically significant relationship with
ROA in model 2 (β = −0.0006, p > 0.10). This implies that COD does not affect firm profitability in our
sample. This may be because our sample comprises relatively large firms listed on the PSX. These
firms do not have significant debt financing and therefore, their performance remains largely
unaffected by changes in COD. This finding is not consistent with the previous literature. For
instance, Dawar (2014) reports a significantly negative relationship between the cost of debt
and firm performance in the context of Indian companies. Weill (2008) and Tsuruta (2015b)
found a positive relationship between the cost of debt and firm performance. In addition, the
results suggest that POLC has a significant and positive association with ROA in model 3
(β = 0.0419, p < 0.01). This implies that firms with political connections have better profitability
as compared to their non-connected counterparts. It has been argued that political connections
contribute to firm performance positively, especially in emerging economies (Guo et al., 2014; Su
Table 1. Descriptive Statistics
Mean
Standard
Deviation
Shapiro-Wilk
statistic
No. of
Observations
ROA 0.0376 0.1138 10.566*** 1005
POLC 0.5820 0.4934 -5.106 1005
TAXAGG 0.7691 0.4215 1.972** 1005
COD 0.2762 2.5434 15.84*** 1005
SIZE 4.4372 1.0285 8.787*** 1005
LEV 0.6877 0.8730 14.677*** 1005
PPE 0.6217 1.1496 15.316*** 1005
Table 2. Pearson Correlations
ROA POLC TAXAGG COD SIZE LEV PPE
ROA 1
POLC 0.2189*** 1
TAXAGG −0.1363*** −0.0668** 1
COD −0.0096 0.0100 0.0221 1
SIZE −0.1644*** 0.0548* −0.0471 −0.0217 1
LEV −0.4668*** −0.0956*** 0.0932*** 0.0200 0.0929*** 1
PPE −0.0829*** −0.0388 0.0628** −0.0073 0.0056 −0.0587* 1
Note: ***, ** and * indicate the statistical significance at the 1%, 5% and 10% levels, respectively.
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Table 3. Panel Regression Results—Baseline Models
FGLS PW PCSE
(1)
ROA
(2)
ROA
(3)
ROA
(1)
ROA
(2)
ROA
(3)
ROA
POLC 0.0419***
(0.0034)
0.0413***
(0.0091)
TAXAGG −0.0047***
(0.0015)
−0.0089*
(0.0052)
COD −0.0006
(0.0004)
−0.0008
(0.0005)
SIZE −0.0099***
(0.0016)
−0.0115***
(0.0016)
−0.0136***
(0.0015)
−0.0104***
(0.0033)
−0.0087
(0.0054)
−0.0141***
(0.0040)
LEV −0.0606***
(0.0033)
−0.0592***
(0.0035)
−0.0610***
(0.0033)
−0.0655***
(0.0094)
−0.0745***
(0.0010)
−0.0686***
(0.0055)
PPE −0.0038***
(0.0011)
−0.0045***
(0.0012)
−0.0049***
(0.0012)
−0.0078**
(0.0031)
−0.0059**
(0.0024)
−0.0058***
(0.0013)
Constant 0.0892***
(0.0100)
0.0921***
(0.0101)
0.0575***
(0.0106)
0.0966***
(0.0253)
0.0823*
(0.0447)
0.0655***
(0.0153)
YEAR_DUMMY Yes Yes Yes Yes Yes Yes
INDUS_DUMMY Yes Yes Yes Yes Yes Yes
R-Squared N/A N/A N/A 0.3145 0.2608 0.4338
Wald-Chi Squared
Statistic
1343.33*** 1159.50*** 1452.81*** 2724.75*** 1055.28*** 10,991.68***
No. of observations 1005 1005 1005 1005 1005 1005
Note: ***, ** and * indicate the statistical significance at the 1%, 5% and 10% levels, respectively.
Abdullah et al., Cogent Economics & Finance (2022), 10: 2132645
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et al., 2014). Politically connected firms may enjoy access to external financing conveniently on
suitable terms (Faccio, 2010), favorable interest rates (Desai & Olofsgard, 2011; Sapienza, 2004)
which leads to better performance. Further, the results suggest that SIZE, LEV, and PPE have
a negative and significant association with ROA. This implies that larger firms with high leverage
and PPE have lower profitability.
4.3.2. Interaction model results
Table 4 presents the panel regression results from the interaction models. The results suggest that
the coefficient of TAXAGG*POLC is positive and statistically significant in model 4 (�= 0.0145,
p < 0.01). This implies that POLC moderates the association between TAXAGG and ROA. In other
words, we find that tax aggressive firms with politically connected board members have better
performance as compared to their non-connected counterparts. This may be because tax aggres-
sive firms are vulnerable to regulatory scrutiny, distrust of shareholders, and scepticism by other
stakeholders which adversely affects their performance (Khuong et al., 2020; Drake et al., 2017;
Balakrishnan et al., 2019; Goh et al., 2016; Guenther et al., 2017; Hasan et al., 2014). However, tax
aggressive firms with politically connected board members may overcome these issues by exploit-
ing political linkages which enables connected firms to avoid regulatory scrutiny without compro-
mising investor sentiments.
Further, the results suggest that the coefficient of COD*POLC is positive and statistically
significant in model 5 (�= 0.0078, p < 0.01). This implies that POLC moderates the association
between COD and ROA. This indicates that firms that have a high cost of debt and politically
Table 4. Panel Regression Results—Interaction Models
FGLS PW PCSE
(4)
ROA
(5)
ROA
(4)
ROA
(5)
ROA
POLC 0.0300***
(0.0044)
0.0398***
(0.0035)
0.0188*
(0.0108)
0.0389***
(0.0100)
TAXAGG −0.0134***
(0.0030)
−0.0222***
(0.0080)
COD −0.0077***
(0.0026)
−0.0099**
(0.0042)
TAXAGG*POLC 0.0145***
(0.0036)
0.0259**
(0.0102)
COD*POLC 0.0078***
(0.0027)
0.0099**
(0.0042)
SIZE −0.0126***
(0.0015)
−0.0130***
(0.0015)
−0.0139***
(0.0041)
−0.0136***
(0.0037)
LEV −0.0622***
(0.0033)
−0.0602***
(0.0034)
−0.0687***
(0.0057)
−0.0664***
(0.0056)
PPE −0.0048***
(0.0012)
−0.0049***
(0.0012)
−0.0056***
(0.0014)
−0.0059***
(0.0014)
Constant 0.0649***
(0.0113)
0.0577***
(0.0105)
0.0846***
(0.0163)
0.0657***
(0.0152)
YEAR_DUMMY Yes Yes Yes Yes
INDUS_DUMMY Yes Yes Yes Yes
R-Squared N/A N/A 0.4451 0.4370
Wald-Chi Squared
Statistic
1827.62*** 1464.48*** 20,356.08*** 25,413.62***
No. of observations 1005 1005 1005 1005
Note: ***, ** and * indicate the statistical significance at the 1%, 5% and 10% levels, respectively.
Abdullah et al., Cogent Economics & Finance (2022), 10: 2132645
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Page 10 of 17
connected board members usually have better performance. This may be because firms with
politically connected boards may overcome the adverse effects of high COD by using their
influence for procuring government projects, concessions, subsidies, and other discretionary
benefits. Further, to cross-validate our main results from FGLS, we employed the PW-PCSE
technique. The PW-PCSE technique is capable of dealing with heteroscedasticity, heterogeneity,
and serial correlation (Bailey & Katz, 2011; Beck & Katz, 1995). Overall, the results are broadly
consistent with our results from the FGLS technique. Thus, the PW-PCSE results cross-validate
our earlier findings and enhance the robustness of our arguments.
5. Further analysis
The further analysis section aims to analyze how political connections influence a firm’s tax
aggressiveness and cost of debt. The existing literature suggests that politically connected
firms usually take sub-optimal decisions (Zhao et al., 2013), pursue their private agenda
(Boubakri et al., 2012), have lower earnings quality (Hashmi, Brahmana & Lau, 2018), and
engage in rent-seeking and tax evasion activities (La-Porta et al., 1998). Therefore, we intend
to investigate whether politically connected firms in Pakistan also engage in tax aggressiveness
and derive benefits in the form of lower cost of debt. In addition, we also investigate whether
the cost of debt is influenced by a firm’s tax aggressiveness. Previous literature indicates that
lenders are reluctant to invest in firms notorious for dubious accounting practices and have
higher risk. Moreover, lenders who are willing to provide financing to such firms may demand
higher returns to be compensated for the additional risk therefore, this may increase the firm’s
cost of debt.
To analyze the influence of POLC on TAXAGG we estimated model 6. The dependent variable in
the model is TAXAGG, which is a dummy variable. Therefore, we employed three binary choice
models i.e. Logit, Probit, and Complementary log-log for empirical analysis. Model 6 is presented
below:
TAXAGG ¼�
1
+�
2
POLC þ�
3
SIZE þ�
4
LEV þ�
5
PPE þ∑�
i
YEARDUMMY þ∑�
j
INDUS_DUMMY+u (6)
Furthermore, models 7 and 8 were estimated to investigate whether POLC and TAXAGG affect
COD, respectively. The models were estimated using the FGLS panel regression technique. Models 7
and 8 are presented below:
COD = �
1
+�
2
POLC+�
3
SIZE+�
4
LEV+�
5
PPE+∑�
i
YEAR_DUMMY+∑�
j
INDUS_DUMMY+u (7)
COD = �
1
+�
2
TAX+�
3
SIZE+�
4
LEV +�
5
PPE +∑�
i
YEAR_DUMMY+∑�
j
INDUS_DUMMY+u (8)
The results of models 6–8 are reported in Table 5. The results of model 6 indicate that politically
connected firms are less likely to be tax aggressive. This is apparent from the negative coefficients of
POLC in model 6 from LOGIT (β = −0.2397, p < 0.1), PROBIT (�= −0.1428, p < 0.1), and complementary
log-log model (β = −0.1331, p < 0.1). The negative association between POLC and TAXAGG is perhaps
due to the increased public visibility and scrutiny of politically connected firms in Pakistan which
deters them from tax evasion. In Pakistan, there is a tendency for political parties to monitor
politically connected firms associated with a rival party, and any misappropriation may be used for
their political gains and advancing campaign propaganda. This finding may be applicable in countries
with weak rule of law and poor investor protection mechanisms. Further, we did not find a significant
effect of POLC on COD in model 7 (�= −0.0015, p > 0.1). However, we find that tax aggressive firms are
likely to have higher COD in model 8 (�= 0.0417, p < 0.01). The positive association between TAXAGG
and COD is perhaps because lenders face higher investment risks and appraisal costs for investing in
firms involved in dubious accounting practices. Therefore, lenders may demand a high rate of return
which ultimately increases the COD.
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Page 11 of 17
Table 5. Further Analysis
LOGIT PROBIT
COMPLEMENTARY LOG-
LOG FGLS
(6)
TAXAGG
(6)
TAXAGG
(6)
TAXAGG
(7)
COD
(8)
COD
POLC −0.2397*
(0.1396) −0.1428*
(0.0815)
−0.1331*
(0.0692)
−0.0015
(0.0103)
TAXAGG 0.0417***
(0.0090)
SIZE −0.1091
(0.0726)
−0.0635*
(0.0361)
−0.0578
(0.0387)
−0.0026
(0.0038)
−0.0071
(0.0047)
LEV 0.6794***
(0.2325)
0.3682**
(0.1476)
0.2923**
(0.1412)
0.0601***
(0.0155)
0.0348**
(0.0177)
PPE 0.5130**
(0.2524)
0.2742*
(0.1485)
0.2183*
(0.1258)
−0.0053*
(0.0028)
−0.0034
(0.0032)
Constant 1.2464***
(0.4358)
0.7801***
(0.2313)
0.4505*
(0.2634)
0.1556**
(0.0665)
0.1144**
(0.0466)
YEAR_DUMMY Yes Yes Yes Yes Yes
INDUS_DUMMY Yes Yes Yes Yes Yes
Pseudo R-Squared 0.0319 0.0315 N/A N/A N/A
Wald-Chi Squared Statistic 23.37*** 21.67*** 29.82*** 194.77*** 243.76***
No. of observations 1005 1005 1005 1005 1005
Note: ***, ** and * indicate the statistical significance at the 1%, 5% and 10% levels, respectively.
Abdullah et al., Cogent Economics & Finance (2022), 10: 2132645
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Page 12 of 17
6. Conclusion
Developing countries face a host of problems such as tax evasion, high cost of financing, political
interference, poor corporate governance, and institutional weaknesses which adversely affect financial
performance and economic growth. The objective of this study is to examine the impact of tax aggres-
siveness and the cost of debt on firm performance. Further, we investigate whether political connections
moderate the association between (i) tax aggressiveness and firm performance and (ii) cost of debt and
firm performance. Our dataset contains a sample of 201 non-financial firms listed on the Pakistan Stock
Exchange. For empirical analysis, we employed two robust panel regression techniques i.e. FGLS and PW-
PCSE. Our results indicate that tax aggressiveness has a significant and negative association with firm
performance while we did not find any significant relationship between the cost of debt and firm
performance. In addition, we find that political connections positively moderate the association
between (i) tax aggressiveness and firm performance and (ii) cost of debt and firm performance. We
find novel evidence that tax aggressive firms with politically connected board members have better
performance as compared to their non-connected counterparts. Moreover, we contend that political
connections may help connected firms in overcoming the adverse consequences of the high cost of debt
by using their influence in procuring government projects, subsidies, and other benefits.
Our results have several implications. First, policymakers should restrict politically connected board
members from using their influential status in an unconstitutional manner by extending favors and
concessions to connected firms. Second, shareholders should use their voting power to enhance the
reporting quality by closely monitoring the tax and other policies of firms which would reduce agency
costs. Third, we strongly recommend stringent policies in emerging economies for ensuring transparency
and safeguarding of shareholders’ interests, especially when firms are politically connected. This is
important as there are ethical repercussions of developing political connections for deriving undue
benefits such as preferential debt financing, avoiding regulatory scrutiny and government subsidies.
Further, the study has some limitations including a limited sample size from a single country and a limited
time horizon. We suggest future researchers examine the nexus between political connections, tax
aggressiveness, cost of debt, and firm performance in a cross-country setting. Moreover, future studies
may examine other consequences of political connections in a sample of developing countries.
Funding
The authors received no direct funding for this research.
Author details
Abdullah
1
E-mail: abdiman.0688@yahoo.com
ORCID ID: http://orcid.org/0000-0001-8400-5295
Muhammad Arsalan Hashmi
2
ORCID ID: http://orcid.org/0000-0003-2336-0431
Abdul Mateen
1
Yousuf Ali Badshah
1
Muhammad Sikander Iqbal
1
1
College of Management Sciences, Karachi Institute of
Economics & Technology, Pakistan.
2
Institute of Business & Health Management, Dow
University of Health Sciences, Pakistan.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Citation information
Cite this article as: Does tax aggressiveness and cost of
debt affect firm performance? The moderating role of
political connections, Abdullah , Muhammad Arsalan
Hashmi, Abdul Mateen, Yousuf Ali Badshah & Muhammad
Sikander Iqbal, Cogent Economics & Finance (2022), 10:
2132645.
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