The Missing “T” in ESG

In recent years, environmental, Social, and Governance (ESG) investing has reached unprecedented heights. Investors are pouring billions of dollars into funds, prioritizing companies with strong environmental records, positive social impact, and good corporate governance. Proponents of ESG investing hail it as a win-win strategy that promises higher financial returns while addressing pressing global challenges like climate change and social inequality. With a risk of a slight exaggeration, the ESG movement often depicts corporations—and, by extension, institutional investors as their largest shareholders—as modern-day saviors of the world, offering a pathway to a better future. ESG rating agencies rank public corporations based on various ESG indicators, bestowing bragging rights on those with the highest scores, allowing them to attract more investments.

In a recent paper, we argue that amidst the enthusiasm about ESG, a critical parameter has gone virtually unnoticed: corporate tax behavior. The payment of corporate taxes is a powerful indicator of how a company views its role in society and supports the communities in which it operates and the stakeholders with whom it engages. Corporate taxes are fundamental to the provision of public goods. They can fuel vital government initiatives, including sustainable governmental initiatives that benefit society, such as environmentally friendly projects, education, welfare, etc.

One would therefore expect corporate tax behavior, particularly the payment of corporate taxes, to be a crucial component within the ESG framework. Reality, however, is a far cry from this ideal. Focusing on the three dominant market actors in the ESG landscape—ESG rating agencies, institutional investors, and public corporations—we identify a glaring gap between the ESG ratings of corporations and their payment of corporate taxes.

To demonstrate this gap, we have examined the criteria used by ESG rating agencies, their methodologies and scoring systems. We then supplemented our findings by direct communications with several agencies. Our investigation reveals a persistent tendency to overlook tax behavior when evaluating companies’ ESG profiles. Specifically, a company’s involvement in tax avoidance—the pursuit of transactions and structures to reduce tax liability in a manner that is contrary to the spirit of the law—hardly impacts its ESG score despite the potential consequences for stakeholders and society.

As part of our research, we examined the ESG scores assigned to companies known for their aggressive tax avoidance behaviors, particularly those that paid no federal income taxes in 2020 despite substantial pretax profits in the United States. Our findings reveal that three out of four ESG rating providers—MSCI, Sustainalytics, and Refinitiv—assigned notably high scores to these companies, indicating a disconnect between tax payment and ESG assessment. For example, among the thirty-seven corporations analyzed in the MSCI sample, three companies attained AAA scores, twelve received AA scores, and ten were awarded A scores. The predominance of A-range scores among these tax-avoiding companies in the MSCI sample supports our assertion that the payment of taxes is not a substantial component of ESG evaluation if it is considered at all.

ESG rating agencies, however, are not solely accountable for the tax-related blind spot. As we show, their most prominent clients—ESG funds and their corresponding fund families—also share the blame. We observed a tendency for ESG funds to favor companies implementing aggressive tax strategies. For example, an analysis of the top ten companies with the highest ESG fund investment in 2020 highlights the prevalence of aggressive tax practices among highly rated companies, such as Microsoft, Alphabet, and Disney. These companies exhibit conspicuously low ETR and have drawn substantial regulatory scrutiny over aggressive tax practices, yet were the biggest winners from stock market investment into ESG funds.

Corporate tax avoidance, however, appears to be not only tolerated by large institutional investors but, in fact, actively encouraged by large institutional investors. According to recent empirical studies, the ownership of broadly diversified institutional investors results in higher tax avoidance levels among their portfolio companies, suggesting that these investors hold a preference for more aggressive tax behavior. Furthermore, despite their campaigns on various ESG issues, large asset managers have refrained from articulating any stance on corporate tax avoidance, even in high-profile cases involving their largest portfolio companies. Several influential institutional investors, including BlackRock and Vanguard, have recently voted against shareholder proposals of three giant tech companies—Amazon, Cisco, and Microsoft—aimed at enhancing tax transparency, mainly through the inclusion of public country-by-country report (“CbCR”) in these companies’ financial statements.

A CbCR provides aggregate data on the global allocation of income, profits, and taxes paid among tax jurisdictions in which the company operates. It is widely acknowledged as a crucial starting point for informed analysis of companies’ tax payments, with the potential to catalyze more responsible tax practices. However, despite its significance, large institutional investors voted against these critical shareholder proposals, resulting in their defeat. BlackRock, the world’s largest asset manager, which also manages various ESG funds, has referred to such shareholder proposals on tax transparency in its 2024 voting guidelines and stated that it would generally not support them.

The emerging pattern suggests that rather than advocating for greater tax compliance that aligns more closely with ESG values, institutional investors, including those at the helm of the nation’s largest mutual ESG funds, may be fueling tax avoidance behavior. Given the broad economic and social implications of corporate tax avoidance, this inclination reflects the illusory promise of asset managers as ESG regulators.

As to public corporations, our analysis of the tax performance of many U.S. corporations lauded for being the promoters of ESG goals reveals that they grossly underpay taxes, leading to unprecedented levels of corporate tax avoidance. For decades, some of the country’s largest and most profitable corporations have found ways to shelter their profits from federal income taxation. According to estimates, tax-avoidance strategies by large multinationals deprive the U.S. government of hundreds of billions of dollars per year, preventing these amounts from ever reaching the public fisc.

The lack of tax-related data in public filings further underscores the disconnect between ESG rhetoric and tax practices. Currently, only two American companies incorporate CbCR into their financial statements, and most public companies do not provide material tax disclosure in their reporting. Perhaps even more striking is that most public companies do not include any meaningful references to their tax policies and payments in their sustainability reports.

The current state of affairs can be best described as a paradox. Corporations are called upon to help solve the very problem they exacerbate through their tax avoidance behavior. This vicious cycle perpetuates as corporate tax avoidance undermines the government’s capacity to pursue ESG goals, leading to increased reliance on corporations and institutional shareholders for ESG advancement.

To fix the problem and break the vicious cycle, we propose implementing changes on three fronts. First, ESG rating agencies must incorporate tax considerations into their ratings with considerable weight. Second, asset managers should explicitly commit to responsible tax behavior in their corporate guidelines and, under certain circumstances, divest from companies whose tax behavior falls below industry peers. Lastly, we advocate for mandatory public disclosure of tax-related information, including adopting a CbCR requirement for all U.S. public companies. Such measures hold promise in discouraging tax avoidance among large multinationals and fostering a more responsible corporate tax culture.

The complete paper is available here. Comments from readers would be most welcome.