Corporate Tax Avoidance and High Powered Incentives

41 Pages Posted: 20 May 2004 Last revised: 13 Aug 2010

See all articles by Dhammika Dharmapala

Dhammika Dharmapala

University of Chicago Law School

Mihir A. Desai

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

Multiple version iconThere are 2 versions of this paper

Date Written: May 2004

Abstract

This paper analyzes the links between corporate tax avoidance, the growth of high-powered incentives for managers, and the structure of corporate governance. We develop and test a simple model that highlights the role of complementarities between tax sheltering and managerial diversion in determining how high-powered incentives influence tax sheltering decisions. The model generates the testable hypothesis that firm governance characteristics determine how incentive compensation changes sheltering decisions. In order to test the model, 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, for the full sample of firms, increases in incentive compensation tend to reduce the level of tax sheltering, suggesting a complementary relationship between diversion and sheltering. As predicted by the model, the relationship between incentive compensation and tax sheltering is a function of a firm's corporate governance. 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.

Suggested Citation

Dharmapala, Dhammika and Desai, Mihir A., Corporate Tax Avoidance and High Powered Incentives (May 2004). NBER Working Paper No. w10471. Available at SSRN: https://ssrn.com/abstract=541687

Dhammika Dharmapala

University of Chicago Law School ( email )

1111 E. 60th St.
Chicago, IL 60637
United States

Mihir A. Desai (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6693 (Phone)
617-496-6592 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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