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Corporate Tax Avoidance and High Powered Incentives

Mihir A. Desai

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Dhammika Dharmapala

University of Chicago Law School

December 2004

This paper analyzes the links between corporate tax avoidance and the growth of high-powered incentives for managers. We develop a simple model that highlights the role of feedback effects between tax sheltering and managerial diversion in determining how high-powered incentives influence tax sheltering decisions. Then, we construct an empirical measure of corporate tax avoidance - the component of the book-tax gap not attributable to accounting accruals - and investigate the link between this measure of tax avoidance and incentive compensation. We find that increases in incentive compensation tend to reduce the level of tax sheltering, in a manner consistent with a complementary relationship between diversion and sheltering. In addition, consistent with a prediction of our model, we find evidence suggesting that this negative effect is driven primarily by firms with relatively weak governance arrangements. Our results may help explain the growing cross-sectional variation among firms in their levels of tax avoidance, the "undersheltering puzzle," and why large book-tax gaps are associated with subsequent negative abnormal returns.

Number of Pages in PDF File: 45

Keywords: Incentive Compensation, Tax Avoidance, Tax Evasion, Diversion, Tax Shelters, Stock Options

JEL Classification: G34, H25, H26, J33, J40, M41, M43, G14

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Date posted: April 19, 2004  

Suggested Citation

Desai, Mihir A. and Dharmapala, Dhammika, Corporate Tax Avoidance and High Powered Incentives (December 2004). Available at SSRN: https://ssrn.com/abstract=532702 or http://dx.doi.org/10.2139/ssrn.532702

Contact Information

Mihir A. Desai (Contact Author)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Harvard Business School - Finance Unit ( email )
Boston, MA 02163
United States
617-495-6693 (Phone)
617-496-6592 (Fax)
Dhammika Dharmapala
University of Chicago Law School ( email )
1111 E. 60th St.
Chicago, IL 60637
United States

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