Why Don’t Firms Claim their Tax Refunds? Evidence from Private Debt Contracts

A puzzle is why a large proportion of firms eligible for income tax refunds do not file claims for such refunds on a timely basis. I hypothesize that firms with private information about higher future profitability and seeking debt financing forgo immediate use of provisions that allow the carryback of net operating losses as a signaling device to separate from firms with lower future profitability in order to obtain more favorable borrowing terms. Firms expecting lower profitability are deterred from mimicking because carrying net operating losses forward is less valuable to them. Consistent with this hypothesis, firms that do not file claims for refunds on a timely basis display higher future profitability and receive lower debt financing costs than firms that file when they first become eligible. These results are stronger when the level of information asymmetry about the borrower’s type is greater. This study is the first to offer a rational explanation for the low take-up rate of tax refunds. As a result, the evidence presented in this study could be relevant to academics and fiscal policy makers that seek to better understand how tax policies affect real decisions. This Draft: February 2016