This paper examines whether participating in tax avoidance activities is related to corporate
debt policy and what the role of cost of debt is in this relation. Using the tax avoidance measure
modified from Desai and Dharmapala (2006), we find the substitution effect of tax avoidance for
the use of debt for a large sample of Korean firms, consistent with Graham and Tucker (2006).
Further tests show that the substitution effect becomes stronger when the cost of debt is high.
These results are robust to a variety of tests for alternative measures of tax avoidance and
debt/asset ratios and endogeneity of tax avoidance. The overall results suggest that the tax
avoidance as non-debt tax shields (NDTS) substitutes for the use of interest tax deductions and
that the tax avoidance activities offer a partial explanation for the underleverage puzzle.
Keywords: Tax avoidance; Capital structure; Cost of debt; Underleverage puzzle; Korean
evidence