In response to greater financial constraints and more costly external financing, firms may avoid corporate taxes to generate funds for investment. In that sense, outside investors may recognize tax management as a value-increasing activity, especially for a financially constrained firm. However, more aggressive tax avoidance may also be associated with increased opportunities for rent diversion by firm managers. Therefore, the impact of corporate tax avoidance on financial constraints is likely to depend on the strength of a firm’s corporate governance. In an article forthcoming in Financial Management [1],  we examine how corporate governance affects the relationship between a firm’s tax avoidance and its financial constraints.

In the wake of major corporate scandals in the early 2000s and the global financial crisis of 2007-2009, there has been a growing interest in research examining the consequences of tax avoidance from a governance perspective. Some of the earlier contributions to this literature argue that corporate tax avoidance cannot be viewed simply as a transfer of wealth from the government to firm shareholders in the presence of agency problems between shareholders and managers [2]. Since tax avoidance usually implies the need to engage in actions that obscure the underlying intent of the transaction, it can provide a shield for managers engaging in a variety of diversionary activities that increase their payouts at the expense of shareholders [3]. Indeed, several high profile corporate scandals at companies such as Enron, Dynegy, and Tyco involved tax avoidance, tax sheltering, earnings manipulation, and accounting fraud or managerial theft.

When firms have weak governance, corporate tax avoidance is likely to coincide with a lack of information, which makes it easier for entrenched managers to divert firm resources for their own benefit, manipulate earnings, and suppress bad news about the firm [3]. In addition to direct costs of tax planning (administrative costs, litigation expenses, and penalties imposed by tax authorities), aggressive tax avoidance, such as tax sheltering, may involve substantial indirect costs, including reputation losses, political trouble, more expensive debt, and a higher risk of stock price crash [4] [5]. Hence, we predict that, assuming poor corporate governance, greater tax avoidance will be associated with increased financial constraints and a greater risk of financial distress.

In contrast, when the interests of managers and shareholders coincide, efficient tax management can provide value to the firm’s shareholders. If the marginal cost of tax avoidance is sufficiently small, additional internal cash flow generated by tax avoidance may reduce the firm’s financial constraints and the risk of financial distress [6]. Strong governance mechanisms with properly structured managerial incentives can ensure that tax avoidance creates value by disciplining the firm’s managers against managerial rent diversion and earnings manipulation [2]. We predict that, with strong governance, greater tax avoidance will not be associated with increased financial constraints.

Because the causality of the relationship between corporate tax avoidance and financial constraints may operate in both directions, we conduct a two-staged least squares (2SLS) analysis with instrumental variables to better identify the impact of tax avoidance on financial constraints conditional on governance quality. We use two measures of corporate tax avoidance – the reduction in the firm’s taxes relative to its pretax accounting income (the long-run cash effective tax rate, Cash ETR) and the tax sheltering measure developed by Wilson [4]. While ETR measures reflect all tax planning activities including the outcomes of regular, fiscally responsible tax management, tax sheltering reflects the propensity of a firm to pursue more aggressive tax avoidance. Our instruments for Cash ETR are the fraction of the population in the county where the firm’s corporate headquarters is located  that claims affiliation with an organized religion (religiosity) and the three-digit SIC industry median value of Cash ETR. Our instrument for tax sheltering is the level of civic norms and strength of social networks within the county of the firm’s headquarters (social capital). Consistent with recent literature, we predict that industry tax avoidance will have a positive impact on a firm’s tax avoidance, whereas both religiosity and social capital in the county where a firm’s headquarter is located will have a negative impact on tax avoidance. We classify firms into groups of strong governance and poor governance, using measures such as the degree of the board’s entrenchment, the level of institutional ownership, whether compensation is based on incentives, and  the number of independent directors. We use an index developed by Whited and Wu [7] to measure the degree of a firm’s financial constraints. Our results remain similar when we use Altman’s Z-score as a measure of financial distress.

Before examining the role of governance, we show that in the sub-sample of constrained firms, both tax management (lower Cash ETR) and tax sheltering (higher sheltering probability) are associated with greater financial constraints. These results are consistent with the notion that outside investors may perceive tax avoidance or tax sheltering as a risky managerial strategy during periods of financial constraints (distress). In contrast, if a firm is not financially constrained, we find that neither tax avoidance nor tax sheltering has a significant impact on financial constraints.

Next, we divide the sample firms into strong governance and poor governance groups based on the median value of the particular governance variable used, as described above. In firms with poor governance, we find that both tax management and tax sheltering are uniformly associated with increased financial constraints across all governance measures. In contrast, the impact of tax management and tax sheltering on financial constraints is mixed, with weakly significant results, and the impact varies with governance measures in firms with strong governance. Our results indicate that corporate governance moderates the impact of tax planning on financial constraints: Tax avoidance is likely to compound the financial constraints of firms with poor governance mechanisms, and it does not have a negative impact on firms with stronger governance mechanisms. This result is consistent with the idea that strongly governed firms use tax management effectively, which can also benefit them in the long-run by not exacerbating their financial constraints.

Overall, our study shows that in the presence of agency problems that create conflicts of interest between managers and shareholders, the effect of tax avoidance on firms’ financial constraints depends on the quality of the corporate governance that disciplines and creates incentives for managers. Corporate tax avoidance is a less useful source of financing for constrained firms when they are plagued with agency problems and a lack of transparency. Constrained firms and their investors stand to benefit from improving their governance practices to mitigate the negative impacts of both tax management and tax sheltering. Tax avoidance can help firms to relax their financial constraints to a certain extent only if they have strong governance.

REFERENCES

1. Bayar, O., Huseynov, F., Sardarli, S., 2018, Corporate Governance, Tax Avoidance, and Financial Constraints, Financial Management, forthcoming. https://doi.org/10.1111/fima.12208
2. Desai, M., Dharmapala, D., 2009. Corporate tax avoidance and firm value. Review of Economics and Statistics 91, 537–546.
3. Hanlon, M., and S. Heitzman, 2010, “A Review of Tax Research,” Journal of Accounting and Economics 50, 127–178.
4. Wilson, R. J., 2009, “An Examination of Corporate Tax Shelter Participants,” The Accounting Review 84, 969-999.
5. Graham, J. R., M. Hanlon, T. Shevlin, and N. Shroff, 2014, “Incentives for Tax Planning and Avoidance: Evidence from the Field,” The Accounting Review 89, 991-1023.
6. Graham, J. R. and A. L. Tucker, 2006, “Tax Shelters and Corporate Debt Policy,” Journal of Financial Economics 81, 563-594.
7. Whited, T. and G. Wu, 2006, “Financial Constraints Risk,” Review of Financial Studies 19, 531-55.

This post comes to us from Associate Professor Onur Bayar at the University of Texas at San Antonio’s College of Business, Associate Professor Fariz Huseynov at North Dakota State University’s College of Business, and Assistant Professor Sabuhi H. Sardarli at Kansas State University. It is based on their recent article, “Corporate Governance, Tax Avoidance, and Financial Constraints,” available here.