The Effect of Industrial Diversification on Firm Taxes

Abstract

This study investigates whether industrial diversification generally provides a tax advantage and how the convexity of the tax system contributes to this benefit. The main findings show multi-industry operations do lower a firm’s taxes and income volatility relative to single industry operations on average, but the benefit is not universal. Namely, there is no significant tax advantage when multi-industry firms have high cross-industry cash flow correlations or when limitations are placed on the convexity mechanism, such as when firms have recent diversifying acquisitions or a high degree of cross-jurisdiction activity. To shed new light on the mechanism through which U.S. firms realize this benefit, I exploit two temporary policies expected to reduce tax convexity via extensions of loss carryback periods. I find these policies also mitigate the tax advantage. Taken together, the results underscore how context matters in determining whether a firm will realize a tax advantage from multi-industry operations.

Keywords: diversification, tax, organizational structure, hedging

JEL Classification: D23, G11, H25, M41