We study the rationale for firms’ use of inside debt by exploiting the relation between firms’
default risk and inside debt (pension and deferred compensation). The classical principal-agent
theory indicates that the agency costs of debt are higher when the firm’s debt is riskier. We test
whether firms that are likely to face more severe agency problems of debt provide more debt
incentives. We provide evidence that less distressed firms use more inside debt. The 2008
financial crisis significantly increases firms’ default risk. This exogenous shift in firms’ default
risk offers an opportunity to provide evidence on the potential causal relation between default
risk and inside debt. Based on a difference-in-differences approach, we find that firms with
increased default risk during the crisis period increase their inside debt significantly less than
those firms with decreased default risk. Overall, we find little evidence to support the hypothesis
that inside debt is used to alleviate the agency costs of debt. Anecdotal evidence suggests that
personal tax concerns appear to be an important determinant for inside debt usage.