In recent years there has been a surge in research that explores the sources of variation in corporate tax avoidance. Following this stream of research, tax scholars have begun to acknowledge the potential effect of ownership patterns on firms’ tax behavior.[1] A few recent empirical studies have examined the effect of institutional ownership, particularly quasi-indexers, on the tax behavior of portfolio firms.[2] These studies found a significant positive correlation between tax avoidance and institutional ownership, indicating that the emerging ownership structure in the U.S. economy – common ownership – plays an outsized role in instances of corporate tax avoidance. As large, diversified institutional investors accumulate shares in the public market, more firms are reducing their tax liability through tax planning.

In my paper, “The Perils of Common Ownership: The Flooding Phenomenon,” I argue that the observed increase in corporate tax avoidance triggers a phenomenon that I call “flooding.” The term is apt because, under this phenomenon, institutional investors push their portfolio firms towards higher levels of tax avoidance. Without adequate measures in place to stem the flow, abnormal levels of tax noncompliance by many public corporations gather the force of a flood, leaving the tax agency floundering. The effectiveness of at least one of the audit stages – commencement, case development, or deficiency collection – is compromised. This, in turn, reduces the probability that such behavior will be detected and adequately penalized.

This flooding effect reflects an overlooked phenomenon that reverses the inherent trade-off between compliance and enforcement. Higher levels of noncompliance are generally associated with a higher probability of enforcement as the tax agency, to deter noncompliance, allocates more of its limited resources towards taxpayers that appear to be more tax aggressive. However, when a large number of taxpayers simultaneously increase their level of tax avoidance, such noncompliant behavior is inadvertently rewarded, as the agency will not have enough resources to effectively counter these emerging levels of noncompliance. This important observation suggests that a firm’s ownership structure affects not only its risk tolerance but also the risk level itself.

The ability to modify enforcement probability through flooding alters the commonly owned firms’ target level of tax avoidance, which is the level that maximizes the firm’s expected utility.[3] In deciding whether to avoid a tax and how much tax to avoid, a firm takes into account the probability of being penalized and the likely magnitude of the sanction. Due to flooding, the target level of tax avoidance increases as the enforcement probability is diminished. This change in the target level of tax avoidance reflects how common ownership can change the way in which public firms approach legal risks and create a tendency among firms to embrace higher levels of noncompliance.

For the flooding effect to materialize, a sufficient number of firms must pursue high levels of tax avoidance. The common ownership structure attests to this exact result. Under this structure, the same institutional shareholders hold stakes in a large number of firms and can, therefore, shape the firms’ tax behavior. As these shareholders evidently favor high levels of tax avoidance, their strong presence in the capital market assures that a noncompliant environment is formed, making tax avoidance an obvious and profitable choice.

In my paper, I identify various potential mechanisms that link institutional ownership to tax noncompliance, some of which fall short of direct communication between institutional investors and their portfolio firms. Furthermore, no communication between corporate managers, let alone coordination or collusion, is required for flooding to occur. The various mechanisms differ in the level of firm-specific knowledge and degree of activity they require from institutional owners and in their effectiveness in increasing tax avoidance. My evaluation of the mechanisms demonstrates that the ability to connect tax avoidance to financial profitability can be utilized to create a noncompliant environment at a relatively low cost.

As the level of institutional ownership continues to rise, curbing the demonstrated positive association between institutional ownership and tax avoidance is essential. My article proposes a double sanctions regime under which institutional investors with 5 percent or more equity stake will be penalized for the tax avoidance behavior of their firms. Such a regime will break the flooding cycle by leading institutional shareholders to pay closer attention to the tax policies of portfolio firms.

Furthermore, the proposal might have a positive side-effect. Given the potential adverse consequences of ownership concentration in the hands of large institutional investors, legal scholars have proposed regulatory changes aimed at limiting the holdings of these investors in their portfolio firms.[4] The suggested policy prescription might prompt institutional investors to reduce their equity stakes below 5 percent on their own initiative.

ENDNOTES

[1] Brad A. Badertscher, Sharon P. Katz & Sonja O. Rego, The Separation of Ownership and Corporate Tax Avoidance, available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1338282; Agnes C.S. Cheng, Henry He Huang, Yinghua Li, Jason Stanfield, The Effect of Hedge Fund Activism on Corporate Tax Avoidance, available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1905544.

[2] Mozaffar Khan, Suraj Srinivasan, Liang Tan, Institutional Ownership and Corporate Tax Avoidance: New Evidence, available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2779809; Shuping Chen, Ying Huang, Ningzhong Li, Terry Shevlin, How Does Quasi-Indexer Ownership Affect Corporate Tax-Planning?, available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2610826); Fariz Huseynov, Sabuhi Sardarli, Wei Zhang, Does Index Addition Affect Corporate Tax Avoidance?, available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2931629.

[3] Jaewoo Kim, Sean Thomas McGuire, Steven Savoy, Ryan J. Wilson, How Quickly Do Firms Adjust to Target Levels of Tax Avoidance?, available at SSRN:  https://pdfs.semanticscholar.org/d450/ee9afaa449251895b4d5 fb6cee311f7181ef.pdf.

[4] Eric A. Posner, Fiona Scott Morton & E. Glen Weyl, A Proposal to Limit the Anticompetitive Power of Institutional Investors, available at SSRN:  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2872754; Lucian A. Bebchuk & Scott Hirst, Index Funds and the Future of Corporate Governance, available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3282794.

This post comes to us from Danielle Chaim, a J.S.D. candidate at Columbia Law School. It is based on her recent paper, “The Perils of Common Ownership: The Flooding Phenomenon,” available here.