Tax Avoidance and Equity Pricing: The Importance of Countries’ Legal Institutions and Disclosure Regulations
Posted: 1 Sep 2021 Last revised: 4 Jan 2022
Date Written: August 30, 2021
In cross-country research, we examine the importance of tax avoidance to equity pricing, and the role that institutional infrastructure plays in shaping this link. Our theoretical framework generates two predictions. First, investors require higher risk premium compensation for their exposure to insiders’ diversion of corporate resources hidden by obfuscatory tax avoidance activities. Second, stronger country-level legal institutions and disclosure environments mitigate this impact. Analyzing a sample of firms from 59 non-U.S. countries, we report strong, robust evidence that equity financing costs rise when firms take more aggressive tax positions. Additional analysis implies that stricter investor protection institutions and sound disclosure regulation alleviate investors’ concerns about insider diversion, moderating the positive impact of tax avoidance on equity pricing. Collectively, our results suggest that investors recognize the complementarity between insider diversion and tax avoidance in less protective environments. Our evidence has major implications for investors and policymakers.
Keywords: Tax avoidance, cost of equity capital, managerial diversion, institutional environments
JEL Classification: G18, G21, G32, G34, H26
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