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The purpose of this paper is to investigate whether tax avoidance has a positive or negative effect on firms’ cost of debt. It further investigates whether the implications for the cost of debt are different for tax avoidance and tax risk.

Based on a sample of 201 firms listed on Frankfurt Stock Exchange from 2009 to 2014, three tests are performed using pooled OLS regression. Controlling for numerous variables that have been found to influence the cost of debt, a first model examines the relationship between tax avoidance and the cost of debt. A second model examines the relationship between tax risk and the cost of debt and a third model interacts tax avoidance with tax risk.

The results show that tax avoidance has a negative effect on the cost of debt; however, tax risk increases the cost of debt. These results indicate that creditors generally view tax avoidance as positive and that tax avoidance is not regarded as inherently risky. Although tax avoidance is rewarded by capital markets with lower interest rates, tax risk contributes to higher interest rates. The effect of tax avoidance on the cost of debt depends therefore on the level of tax risk.

This paper contributes to two distinct strands of research: literature investigating the driving factors behind the cost of debt and literature investigating the consequences of firms’ tax avoidance activities.