Competitive Externalities of Tax Cuts

• Published date: 01 March 2022
• Author: MICHAEL P. DONOHOE,HANSOL JANG,PETRO LISOWSKY
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/1475-679X.12403

DOI: 10.1111/1475-679X.12403

Journal of Accounting Research

Vol. 60 No. 1 March 2022

Printed in U.S.A.

Competitive Externalities of

Tax Cuts

MICHAEL P. DONOHOE,∗HANSOL JANG,†

AND PETRO LISOWSKY‡

Received 18 January 2019; accepted 31 May 2021

ABSTRACT

We examine how tax cuts that benefit some firms are related to the economic

performance of their direct competitors. Consistent with tax cuts decreasing

the cost of initiating competitive strategies, we find that a decrease in the tax

burden for only a specific group of firms in the U.S. economy (i.e., “rivals”)

has a negative economic effect on the performance of its direct competitors

not directly exposed to the same tax cut (i.e., “competitors”). This negative

externality is stronger when the relatively higher taxed competitors (1) are

financially constrained, (2) operate in more competitive markets, (3) have

similar products to their lower taxed rivals, (4) face rivals that retain more of

their cash tax savings due to lower dividends and share repurchases, and (5)

∗University of Illinois at Urbana-Champaign; †National University of Singapore; ‡Boston

University and Norwegian Center for Taxation

Accepted by Christian Leuz. We appreciate helpful comments from William Ciconte, Paul

Demeré, Fei Du, Alex Edwards, Brian Gale, Kamber Hetrick, Sara Malik, Lillian Mills, Mar-

cel Olbert, Caspar David Peter (discussant), Matthias Petutschnig (discussant), David Samuel,

Harm Schütt, Lisa De Simone (discussant), Jake Thornock, Oktay Urcan, Shuyang Wang, Hay-

oung Yoon, two anonymous reviewers, and workshop and research session participants at the

American Taxation Association Midyear Meeting, American Accounting Association Annual

Meeting, Berlin-Vallendar Conference on Tax Research, Boston University Accounting Con-

ference, UCLA Accounting Conference, Brigham Young University,Ludwig-Maximillian Uni-

versity of Munich, University of Hong Kong, University of Notre Dame, University of Illinois

at Urbana-Champaign, University of Mannheim, University of Miami, University of Missouri,

and Vienna University of Economics and Business. Donohoe appreciates the support of the

PwC Faculty Fellowship at the University of Illinois at Urbana-Champaign. Repatriation data

used in this manuscript are available from the authors upon request.

201

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School

of Business

202 m. p. donohoe, h. jang, and p. lisowsky

face lower taxed, but financially constrained, rivals. We also find that share-

holders and lenders price the negative externality manifested in these com-

petitors’ economic performance.

JEL codes: D40, H23, H25, M40, M41

Keywords: American Jobs Creation Act of 2004 (AJCA); product market;

competition; repatriation

1. Introduction

Corporate tax cuts can serve as a policy tool to boost corporate investment

and job growth (Feldstein [1970], King [1977], Auerbach [1979], Bradford

[1981], Poterba and Summers [1985], House and Shapiro [2008], Zwick

and Mahon [2017], Blouin et al. [2021]). However, some firms stand to

benefit disproportionately more than other firms based on whether and the

extent to which those firms qualify for the tax relief. In a setting where only

some firms receive tax cuts, it is unclear what the implications are on the

economic performance of competitor firms that do not directly benefit from

the tax cuts. In this paper, we ask whether and to what extent variation in

tax benefits yields competitive externalities by rendering firms that do not

receive tax benefits at a competitive disadvantage compared to firms that

do.

The main argument of the paper is as follows: Facing product market

competitors, a firm vies for greater market share by engaging in compet-

itive strategies. These strategies, such as price wars, store locations, target

advertising, and product improvements and differentiation, are costly. If

the costs of the strategies are less than the expected return from dominat-

ing the product market, a firm is incentivized to implement them. Tax cuts

can reduce the costs associated with competitive strategies. For example,

temporary tax breaks, such as the repatriation tax holiday of the Ameri-

can Jobs Creation Act of 2004 (AJCA) or changes in the bonus deprecia-

tion rules in the early 2000s, can generate tax savings that lower internal

financing costs and, perhaps, cover the fixed costs associated with a variety

of competitive actions. Permanent tax cuts, such as the Tax Reform Act of

1986 and the Tax Cuts and Jobs Act of 2017 (TCJA), can similarly reduce

the marginal cost of competitive strategies. When tax benefits are hetero-

geneous across firms, the firm with the lowered cost of competitive strate-

gies will pursue those strategies against competitors who do not receive tax

benefits in order to (1) dampen those competitors’ ability to fund future

investments, (2) cause those competitors’ financial constraints to bind, (3)

encourage those competitors to exit the market, and (4) increase the prob-

ability of capturing a larger market share in the long run. In the short run,

the competitors’ operating performance will reflect the competitive actions

brought against them.

Economic theory and empirical evidence illustrate the presence of com-

petitive strategies and their subsequent effects. Relying on theoretical in-

sights from Benoit [1984] and Bolton and Scharfstein [1990], empirical

competitive externalities of tax cuts 203

studies identify channels through which product market competition is af-

fected. For instance, using deregulation as a setting, prior research inves-

tigates how leverage, financial constraints, and cash balances (i.e., “deep

pockets”) affect product market competition in post-deregulation periods

(Zingales [1998], Fresard [2010]). Other studies examine how corporate

disclosure is strategically used to preempt or reduce the risk of product mar-

ket rivals’ competitive strategies, and how shocks to information asymmetry

between capital providers and borrowers invite product market rivals’ com-

petitive actions (Bernard [2016], Billett, Garfinkel, and Yu [2017]).

We add to this literature on product market competition by identifying

the competitive effects of tax cuts; namely, the tax channel of competition.

Proponents of tax cuts tout increases in real investment (e.g., equipment

purchases) and job creation as their economic rationale, and there is em-

pirical evidence supporting such claims with respect to the recipients of the

tax cuts (House and Shapiro [2008], Djankov et al. [2010], Zwick and Ma-

hon [2017]). However, it is also possible that tax cuts play a role in in-

centivizing beneficiary firms to fund competitive strategies that negatively

affect their competitors’ operating performance.

To study whether tax cuts affect product market competitors, we must

overcome two obstacles: (1) find an empirical setting in which we can

separate firms that received tax benefits from those that received little

to no tax benefits from the same tax cut; and (2) identify product mar-

ket rivals. Addressing the first obstacle, the repatriation tax holiday under

the AJCA provides such a setting because only a subgroup of firms—U.S.

multinationals—stood to benefit from the repatriation tax holiday during

which the U.S. tax rate on foreign earnings decreased from 35% to 5.25%.

We hand-collect firms’ repatriation amounts from their financial reports

(i.e., 10-Ks, 10-Qs, and 8-Ks), and infer the extent to which they benefited

from the AJCA through the level of repatriated foreign earnings (i.e., a firm

should repatriate more as the benefit from the tax holiday increases).

To address the second obstacle, we rely on the Hoberg and Phillips

[2016] Text-based Network Industry Classification (TNIC) data to identify

product markets based on firms’ pairwise similarity in their 10-K business

and product market descriptions. Because product market rivals identified

in the TNIC data are unique to each firm and are time variant, each firm

has its own product market, which may comprise different rivals in different

years. The advantages of using TNIC data, instead of SIC or NAICS industry

groups, to define the product market space are detailed in subsection 3.1.1

Using the AJCA as our empirical setting and TNIC data to define prod-

uct markets, we employ a generalized difference-in-differences research de-

sign that accommodates staggered treatments to identify the competitive

externalities of tax cuts. This design identifies differences in economic per-

formance across nonrepatriating firms when their rivals repatriate versus

1For more information on the TNIC data and construction of the pairwise similarity score,

see Hoberg and Phillips’ online data library (http://hobergphillips.usc.edu).