Tax Avoidance and Equity Pricing: The Importance of Countries’ Legal Institutions and Disclosure Regulations

Abstract

In cross-country research, we examine the importance of tax avoidance to equity pricing, and the role that institutional infrastructure may play in shaping this link. Analyzing a sample of firms from 58 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.

Keywords: Tax avoidance, cost of equity capital, managerial diversion, institutional environments

JEL Classification: G18, G21, G32, G34, H26