Survival of the Tax Fittest: Path Dependence in Corporate Tax Planning

Abstract

We investigate the potential of path dependence in explaining cross-sectional variation and persistence in efficient corporate tax planning. Variation in corporate tax planning among firms is far from fully understood. We propose that corporate tax planning strategies are path dependent. This implies that, once a business strategy is adopted, the range of tax strategies available to the firm is narrowed. If a more efficient tax planning strategy emerges, path dependence hampers firms from adopting that option, potentially resulting in tax planning inefficiencies. We compare new entrants to a market with incumbent firms and find that new entrants have an entrant’s tax edge; that is, new entrants are more efficient in tax planning compared to incumbent firms. Consistent with our predictions and path dependence theory, we find that the entrant’s tax edge is amplified when incumbent firms in the market are relatively inflexible. Finally, we explore whether new entrants use their tax edge as a competitive mechanism. We find new entrants only outperform incumbents in tax planning efficiency when competition is strong, and not when competition is weak.

Keywords: Path dependence, corporate taxation, flexibility, competition, strategy