We study price and non-price provisions of debt contracts to gauge how creditors evaluate changes in senior executives’ personal income taxes (“managerial taxes”) of their borrowers. Because managers’ personal income taxes can exacerbate conflicts of interest with their firms’ capital providers (e.g., creditors and shareholders)—as well as those between them—they should influence the design of these contracts. We argue that an increase in personal taxes affects how managers evaluate risk-return trade-offs and encourages them to take more risk. Specifically, by enabling risk-sharing with the government, taxes reduce the disincentive of a risk-averse managers to pursue risky projects by reducing the disutility they associate with them. Our evidence demonstrates that loans issued following arguably exogenous increases in managerial taxes are costlier for borrowers and are more likely to include performance rather than capital covenants. Subsequent cross-sectional tests corroborate this inference and provide further insight by showing that the effect of managerial taxes on loan terms is more pronounced when managers have greater incentives to take risks, and when creditors are more likely to closely monitor managers’ risk-taking behavior. Collectively, these and other findings show how changes in managerial taxes—and, in turn, managers’ preferences for risk and return—influence the terms and structure of their firms’ debt contracts.
