Tax Avoidance, Uncertainty, and Firm Risk

Abstract

We examine the relation between tax avoidance and firm risk using latent class mixture models, identifying subsamples 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, 42 percent exhibits a negative association, and 39 percent does not exhibit a significant relation. Our analyses reveal striking differences in firm characteristics across latent classes, including the use of common tax shields and cross-border tax planning. Using the results from the latent class mixture model, we develop a parsimonious model to predict whether a firm-year observation is likely to exhibit a positive (negative) relation between tax avoidance and firm risk. Firms predicted to exhibit a positive relation between tax avoidance and firm risk experience negative tax outcomes over the following three years, including larger payouts to tax authorities and more negative tax news coverage. Overall, our results suggest the relation between corporate tax practices and firm risk varies substantially across large groups of firms.

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

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