The Effect of Industrial Diversification on Firm Taxes

Abstract

This study investigates a prediction in finance that diversified firms typically have a tax advantage over single industry firms and that the mechanism for this benefit is tied to the convexity of the tax system. Consistent with these predictions, the results suggest that diversified firms have less volatile income streams and lower tax burdens than single industry firms, on average. The results show substantial variation in the tax benefit and, in some cases, a tax cost with diversification. For identification, this study exploits two temporary tax law changes expected to alter tax convexity using a triple difference method, finding that the convexity mechanism is an important channel for the diversification tax benefit. Cross-sectional tests reveal that the diversification tax benefit is likely driven by firms with the fewest frictions to exploit these benefits, like firms with only domestic operations, as opposed to multinationals where jurisdictional frictions represent a binding impediment.

Keywords: diversification, tax, organizational structure, hedging

JEL Classification: D23, G11, H25, M41