The Effect of Industrial Diversification on Firm Taxes

Abstract

This study investigates whether industrial diversification typically provides a tax advantage over operations in a single industry and how income volatility along with the convexity of the tax system contribute to this benefit. The main finding is that multi-industry operations typically lower a firm’s taxes relative to single industry operations. While the results suggest multi-industry operations correspond with substantially lower income volatility, on average, the tax benefit is not universal, as I do not observe evidence for the tax advantage when multi-industry firms have high cross-industry cash flow correlations. Further, when a limitation is placed on the convexity mechanism such as when firms have recent diversifying acquisitions or a high degree of cross-jurisdiction activity, the results also do not provide evidence for the tax advantage. For identification, this study also exploits two temporary tax law changes expected to alter tax convexity using a triple difference analysis.

Keywords: diversification, tax, organizational structure, hedging

JEL Classification: D23, G11, H25, M41