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. Further, the results show substantial variation in the tax benefit and, in some cases, a tax cost with diversification, depending on the firm’s primary industry. Findings are robust to matched sample analysis and additional controls for factors expected to influence both the decision to diversify and firm taxes. Finally, this study exploits two temporary tax law changes expected to alter the convexity of the U.S. tax system, providing evidence that the convexity mechanism is an important channel for the tax implications of diversification.

Keywords: diversification, tax, organizational structure, hedging

JEL Classification: D23, G11, H25, M41