How Tax Avoidance Affects Shareholder Value

In my recent paper, Tax Avoidance, Income Diversion, and Shareholder Value: Evidence from a Quasi-Natural Experiment, I examine how the interaction between the corporate tax system and corporate governance affects firm value. To this end, I empirically investigate two main questions. First, do investors value corporate tax avoidance? I find that, on average, they do. Second, does the corporate tax system (which includes both taxes and tax enforcement) affect the level of income diversion? I find that market reactions suggest that higher tax rates can erode good corporate governance  by increasing the return from income diversion, and that stricter tax enforcement can actually increase (rather than decrease) firm value.

Corporate tax avoidance refers to a variety of tax planning strategies aimed at reducing explicit taxes paid[1]. The main—and fairly straightforward—benefit of tax avoidance is a reduction in the overall corporate tax burden. Nevertheless, there are some costs associated with tax avoidance, such as reputational harm, the time and fees of tax experts, and the risk of being caught and challenged  by tax authorities.. To the extent that firms attempt to minimize these costs to make tax avoidance valuable, some of the more aggressive forms of tax avoidance are designed to obfuscate, and it is often unclear how they are conducted and  reported. These strategies could in turn facilitate resource diversion and rent extraction by managers or controlling shareholders, and essentially lead to indirect costs (from tax avoidance) for minority shareholders arising from agency problems.

Given that tax avoidance may create an agency problem (Desai and Dharmapala (2006)), how might shareholders be affected? It is an empirical question whether corporate tax avoidance is value enhancing or destroying from an outside investor’s perspective, prompting the question: How does tax avoidance affect firm value? Several empirical papers have addressed that question within this new framework, and the evidence  is mixed.

Furthermore, an influential paper by Desai, Dyck, and Zingales (2007) recognizes this complementary relationship between tax avoidance and income diversion, and provides a theoretical framework that links taxation to corporate governance. The authors predict that higher tax rates may harm corporate governance by increasing the return from income diversion, and that stricter tax enforcement can actually increase the market value of a firm if it reduces income diversion. Nevertheless, given the obvious difficulty in identifying and measuring income diversion and in constructing proxies for tax enforcement, few studies have empirically tested these predictions.

I exploit a quasi-natural experiment provided by a recent tax reform in South Korea and examine the stock market response to the reform to assess whether investors perceive that tax avoidance enhances value and whether the tax system can affect income diversion. I exploit differences in how aggressively firms try to avoid taxes, the extent to which they are owned by insiders, and the level of tax enforcement against them. My empirical strategy allows me to alleviate the concern that both tax avoidance and income diversion are potentially endogenous firm decisions, and that their effect on shareholder value could already be incorporated into stock prices. Moreover, extant theory that examines the relation between corporate taxes and corporate governance is developed within an international corporate governance framework, one that highlights conflicts between insiders and outsiders. Therefore, South Korea is a fitting research venue to answer questions that involve agency problems due to poor corporate governance (e.g., diversion by insiders). Using this tax reform, I identify a causal effect of tax avoidance on firm value (consistent with the standard view), and provide empirical evidence that the interaction between corporate taxes and governance can affect shareholder value. These results withstand various robustness tests that rule out alternative explanations and interpretations.

The tax reform I focus on was announced on August 6, 2014 by the Korean Ministry of Strategy and Finance and was designed to encourage firms to invest in profitable opportunities when possible or disgorge their current year earnings to existing shareholders and employees. The law imposes an additional 10 percent tax on after-tax profit for firms that have equity capital exceeding 50 billion Korean Won[2] and that fail to spend (1) 80 percent of corporate income on investments, cash payments to shareholders, or non-executive employee wage increases or (2) 30 percent of corporate income on cash payments to shareholders or non-executive employee wage increases.

I first examine how investors perceive the effect of corporate tax avoidance on firm value. I find that for firms expected to incur higher taxes, those with higher levels of tax avoidance experience a statistically significantly lower drop in shareholder value.  For some economic perspective, a change from the 10th to the 90th percentile in the level of tax avoidance translates to an average change of approximately $10 million in market value after controlling for size, growth opportunities, and industry. I interpret this as evidence that investors believe corporate tax avoidance, on average, increases value.

Next, I examine the interplay between corporate taxation and corporate governance. First, I investigate whether higher tax rates can harm corporate governance by increasing the return from income diversion. Using ownership structure to capture the increased incentive to extract private benefits, I find that firms that are expected to pay more taxes and that have a greater degree of inside ownership experience a significantly larger drop in market value during the tax reform period. Second, I test the notion that greater tax enforcement can lead to higher firm value. While counter-intuitive, this prediction is consistent with the claim that even with increased levels of taxation, stricter tax enforcement can benefit shareholders by restricting income diversion. Using hand collected data from the Korean National Tax Service and data from the leaks of offshore tax accounts by the International Consortium of Investigative Journalists (ICIJ), I construct several measures of tax enforcement and find that the market response to the tax reform is less negative for firms operating in regional tax offices with stricter tax enforcement. Taken together, these two findings provide empirical evidence in support of the theoretical framework proposed in Desai, Dyck, and Zingales (2007) that links corporate taxes to corporate governance.

This study has implications for economic policy. The Korean finance ministry conveyed that the main objective of this tax reform is to spur economic growth and strengthen the link between corporate earnings and household income by discouraging companies from hoarding cash. In other words, the government is using taxes to try to improve corporate governance at Korean firms. Therefore, a main takeaway from this study is that tax policy analysis should account for agency issues.


Desai, M. A., & Dharmapala, D. (2006). Corporate tax avoidance and high-powered incentives. Journal of Financial Economics, 79(1), 145-179.

Desai, M. A., Dyck, A., & Zingales, L. (2007). Theft and taxes. Journal of Financial Economics, 84(3), 591-623.

Hanlon, M., & Heitzman, S. (2010). A review of tax research. Journal of Accounting and Economics, 50(2), 127-178.


[1] Throughout this paper I do not address the legality of the tax position in question. Consistent with the existing literature on tax avoidance, I use the generic term tax avoidance broadly defined to incorporate terms like tax aggressiveness, tax sheltering, and tax management (see, for example, Desai and Dharmapala (2006) and Hanlon and Heitzman (2010)).

[2] At the won/dollar exchange rate of 1099.15 on 12/31/2014, the cutoff is roughly 45.5 million US dollars.

This post comes to us from Samer R. Semaan, a Ph.D. candidate in finance at Purdue University’s Krannert School of Management. It is based on his recent article, “Tax Avoidance, Income Diversion, and Shareholder Value: Evidence from a Quasi-Natural Experiment,” available here.