We show that when large corporations are subject to a different tax system than smaller firms, the agency cost of under‐ and overinvestment is significantly altered. In contrast to the findings in the literature, the gap between the first‐ and second‐best investment trigger prices do not move in lockstep with variations in the corporate tax rate, as in the case of a linear tax system. We show that the gap can either widen or shrink, depending on the tax policy design and regime. In addition, we find that the agency cost under a progressive tax regime is considerably larger than the agency cost under a regressive tax regime when equityholders have to bear all the investment costs. These results are reversed when managers have the ability to issue additional debt to finance the firm's expansion and transfer part of the investment costs to bondholders.

I provide evidence that covenants in bond indentures affect firms' investment policies outside of covenant violations. After controlling for the self-selectivity of covenant inclusion, I find that firms decrease (increase) capital expenditure after issuing bonds with investment (financing) restrictions. Firms that are more financially constrained or overinvesting are the most affected by investment restrictions, whereas only underinvesting firms see a positive effect from financing restrictions.My results provide empirical evidence that bond covenants help mitigate agency problems related to investment distortions, and especially that covenants restricting financing activities can alleviate the underinvestment problem.

We use an exogenous, forward-looking measure of price uncertainty to examine the effect of uncertainty on the use of covenants in private and public debt contracts. The effect of uncertainty differs significantly in loans versus bonds, suggesting that private and public lenders face different incentives when contracting under high uncertainty. In loans, uncertainty increases the use of performance-based covenants. In contrast, covenant usage decreases in bonds, but firms with low agency conflicts mainly drive this effect. However, bondholders require higher spreads to offset the lack of protection with fewer covenants. Hedging does not affect the covenant-uncertainty relationship for debt contracts.

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