Does Corporate Tax Avoidance Impair Earnings Informativeness?

Abstract

We investigate a previously overlooked type of non-tax cost associated with tax avoidance: the potential loss of earnings informativeness. Expected benefits from corporate tax planning include positive effects on after-tax earnings and an increase in firm value. However, tax avoidance can entail opaqueness which clouds investors’ view on firm performance and reduce earnings informativeness. We run multiple tests on a large U.S. firm sample over the period 1993 to 2012. First, we find that tax avoidance is significantly negatively associated with earnings informativeness, as measured by the Earnings Response Coefficient (ERC) derived from a standard pricing model. Second, we introduce a dynamic partial adjustment model to study the overall firm information quality and show that firms may not be able to compensate for the tax-related loss in earnings informativeness, e.g. by providing other (non-earnings) information. Third, we extend our research design to better control for a number of factors known to affect the ERC, such as firm growth, risk, size, and leverage (Collins and Kothari [1989]). Beyond GAAP and Cash effective tax rates, we use a range of alternative tax avoidance proxies (e.g. Frank, Lynch and Rego’s [2009] DTAX measure, Wilson’s [2009] tax shelter probabilities) to further validate our findings. Results consistently suggest that higher levels of tax avoidance are associated with lower earnings informativeness and that this finding is likely not limited to particularly aggressive types of tax avoidance.

Keywords: tax avoidance, tax planning, earnings informativeness, partial adjustment model

JEL Classification: G12, G14, H20, M41