Tax Avoidance, Uncertainty, and Firm Risk

Abstract

While tax avoidance strategies result in greater after-tax cash flows, they can involve uncertain future outcomes, which can impose significant costs on firms. Thus, the extent to which tax avoidance increases firm risk is unclear. This paper re-examines the relation between tax avoidance and firm risk using latent class mixture models, which identify sub-samples of firms with differing relations between variables of interest. We provide evidence that 19 percent of our sample exhibits a positive association between tax avoidance and firm risk, 43 percent exhibits a negative association, and 38 percent does not exhibit a statistically significant relation. Our analyses suggest striking differences in firm characteristics across the latent classes, including differences in the use of common tax shields such as net operating loss carryforwards, interest expense, and capital expenditures; variation in tax planning as reflected in effective tax rates, settlements with tax authorities, and foreign income; firm size and profitability; operating volatility and information environments; and managerial compensation incentives and stock ownership. Our findings increase our understanding of the circumstances in which tax avoidance is positively, negatively, or not significantly related to firm risk.

Keywords: Tax avoidance, firm risk, stock return volatility, latent class mixture model

JEL Classification: G14, G32, M21, M40, M49