Aggregate Corporate Tax Avoidance and Cost of Capital

42 Pages Posted: 5 Sep 2020

See all articles by Stephanie Sikes

Stephanie Sikes

University of Illinois at Chicago - College of Business Administration

Robert E. Verrecchia

University of Pennsylvania - Accounting Department

Date Written: June 30, 2020

Abstract

We identify a pecuniary externality arising from corporate tax avoidance. Firms share risk with the government via taxation. The lower the tax rate applied to a firm’s earnings, the more risk is borne by its shareholders. As more firms engage in avoidance in the aggregate, the variance of the market’s after-tax cash flow increases. Consequently, the covariance of a firm’s cash flow with the market cash flow, and thereby its cost of capital, increases. This occurs both for firms that avoid taxes and for those that do not. Consistent with our prediction, we find that firms’ implied cost of capital is positively related to aggregate corporate tax avoidance. This result holds not only for tax-avoiding but, crucially, also for non-tax-avoiding firms. As we predict, the pecuniary externality is stronger for firms whose cash flow covaries more with the market cash flow, and is driven by tax avoidance strategies that reduce a firm’s marginal tax rate as opposed to reducing its tax base.

Keywords: Corporate Tax Avoidance, Cost of Capital, Expected Rate of Return, Risk-Sharing

JEL Classification: G12, G18, G32, H25, H26, M41

Suggested Citation

Sikes, Stephanie and Verrecchia, Robert E., Aggregate Corporate Tax Avoidance and Cost of Capital (June 30, 2020). Available at SSRN: https://ssrn.com/abstract=3662733 or http://dx.doi.org/10.2139/ssrn.3662733

Stephanie Sikes (Contact Author)

University of Illinois at Chicago - College of Business Administration ( email )

601 South Morgan Street
11th Floor
Chicago, IL 60607
United States

Robert E. Verrecchia

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-6976 (Phone)
215-573-2054 (Fax)

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