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E-MailThe following post comes to us from Jeong-Bon Kim, Professor of Accountancy at City University of Hong Kong; Yinghua Li of the Accounting Department at Purdue University; and Liandong Zhang of the Department of Accountancy at City University of Hong Kong.
In the paper, Corporate Tax Avoidance and Stock Price Crash Risk: Firm-Level Analysis, which is forthcoming in the Journal of Financial Economics, we examine the association between the extent of a firm’s tax avoidance and its future stock price crash risk. Recently, Desai, Dyck, and Zingales (2007) and Desai and Dharmapala (2006) put forth a “theft and taxes” idea: Complex tax avoidance arrangements can provide management with the tools, masks, and justifications for rent-diverting activities, such as earnings manipulation, unauthorized compensation, and insider trading. The purpose of our paper is to test this “theft and taxes” idea in the context of stock price crash risk.
We argue that some aggressive and complex form of tax avoidance strategies, such as tax sheltering, facilitate managerial rent diversion and bad news hoarding for extended periods. The hoarding and accumulation of bad news for extended periods, in turn, lead to stock price crashes when the accumulated hidden bad news crosses a tipping point, and thus comes out all at once. For empirical analysis, we construct three proxies for tax avoidance: the probability of tax sheltering, long-run cash effective tax rates, and book-tax difference. Using a large sample of U.S. firms for the period 1995-2008, we find that firms with higher tax sheltering probabilities, lower long-run cash effective tax rates, and larger book-tax difference are more likely to experience firm-specific stock price crashes in the future. This result is robust to controlling for accrual manipulation, investor heterogeneity, and other known determinants of crash risk. In addition, we show that the positive association between tax avoidance and crash risk is diminished firm firms with stronger external monitoring.
Overall, our paper provides one piece of evidence for the fairly young idea that tax avoidance facilitates rent diversion. Moreover, our paper identifies an economically meaningful predictor for future stock price crash risk, which can be useful for portfolio management.
The full paper is available for download here.
