Corporate Governance, Tax Avoidance, and Financial Constraints

• Author: Sabuhi Sardarli,Fariz Huseynov,Onur Bayar
• Published date: 01 September 2018
• Date: 01 September 2018
• DOI: http://doi.org/10.1111/fima.12208

Corporate Governance, Tax Avoidance,

and Financial Constraints

Onur Bayar, Fariz Huseynov, and Sabuhi Sardarli∗

We examine howcorporate governance affects the relationship between corporate tax avoidance

and financial constraints. Conditional on having poor governance, tax avoidance is associated

with greater financial constraints and a greater likelihood of financial distress. In firms with

strong governance, however, we find that tax avoidance does not have a negative impact on

financial constraints. Our results suggestthat tax avoidance is a less useful source of financing for

constrained firms when they are plaguedwith potential agency problems and opaque information

environments.Stronger governancemechanisms can help f irms mitigatethe negative consequences

of tax avoidance.

We examinehow corporate governance affects the relationship between a firm’s tax avoidance

behavior and its financial constraints.1A growing stream of finance and accounting literature

has investigated how firms can use corporate tax avoidance as a source of financing for their

investment opportunities in response to greater financial constraints.2However,so f ar, the extant

literature has not explored the potentially important effect of managerial incentives and corporate

governance on the endogenousrelation between corporate tax avoidance and financial constraints.

Our objective is to fill this gap in the literature by analyzing whether the impact of corporate tax

avoidance on financial constraints depends on the quality of a firm’s governance mechanisms

and whether shareholders can properly discipline their managers to increase the value efficiency

of tax avoidance. Further, wedistinguish between f iscally responsibletax management and more

aggressive tax sheltering, and investigate which forms of tax avoidance strategies firms can

effectively use to relax their financial constraints depending on the quality of their governance

mechanisms.

In the wake of major corporate scandals in the early 2000s and the global financial crisis of

2007–2009, there has been a growing interest regarding research examining the consequences

Weare grateful to conference participants at the 2015 Midwestern FinanceAssociation meetings and the 2016 Financial

Management Association meetings for helpful comments and discussions. Special thanks to an anonymous refereeand

Raghavendra Rau (Editor) for their helpful comments and suggestions. We alone are responsible for any errors or

omissions.

∗Onur Bayar is an Associate Professor of Finance in the Collegeof Business at the University of Texas in San Antonio,

TX. Fariz Huseynov is an Associate Professor of Finance in the College of Business at North Dakota State University

in Fargo, ND. Sabuhi Sardarliis an Assistant Professor of Finance in the College of Business Administration at Kansas

State University in Manhattan, KS.

1Weuse the terms tax planning and tax avoidance interchangeably to describe all actions taken by managers to reduce the

cash tax liabilities of their firm. Throughout the study, tax management refers to regular fiscally responsible tax planning

strategies that are in full compliance with tax laws,whereas tax sheltering refers to more aggressive tax planning strategies

resulting from aggressive interpretations of ambiguous areas within the tax laws. Shackelford and Shevlin (2001) and

Hanlon and Heitzman (2010) review the literature on the determinants of a firm’s tax avoidancebehavior.

2The survey evidence of Graham et al. (2014) suggests that financially constrained firms are more likely to manage their

taxes to obtain cash savings. Law and Mills (2015) find that financially constrained firms pursue more aggressive tax

planning strategies. In a concurrent study,Edwards, Schwab, and Shevlin, 2016 find that f irms facing increased financial

constraints exhibit decreases in cash effective tax rates (ETRs).

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652 Financial Management rFall 2018

of tax avoidance from a governance perspective. While outside investors may recognize tax

management as a value-increasing activity for a financially constrained firm, more aggressive tax

avoidance practices may also be associated with increased opportunities for rent diversion by the

firm’smanagers. Slemrod (2004), Crocker and Slemrod (2005), and Desai and Dharmapala (2006,

2009) argue that corporate tax avoidance cannot be simply viewed as a transfer of wealth from

the government to firm shareholders in the presence of agency problems between shareholders

and managers. Because tax avoidance usually implies the need to engage in actions that obscure

the underlying intent of the transaction, it can simultaneously provide a shield for managers

engaging in a variety of diversionary activities that increase their payouts at the expense of

shareholders.3

When firms have weak governance mechanisms, corporate tax avoidance is likely to coincide

with more opaque information environments in which entrenched managers divert firm resources

for their own private benefits, manipulate earnings, and hoard bad news about the firm (Lev

and Nissim, 2004; Hanlon, 2005; Hanlon and Heitzman, 2010). In addition to direct costs of

tax planning (administrative costs, litigation expenses, and penalties imposed by tax authorities),

aggressive tax avoidance activities, such as tax sheltering, may involve substantial indirect costs

including potential reputation losses, political costs, a greater cost of debt, and a higher stock

price crash risk (Hanlon and Slemrod, 2009; Wilson, 2009; Kim, Li, and Zhang, 2011; Graham

et al., 2014; Hasan et al., 2014). Hence, we predict that conditional on poor corporate governance,

greater tax avoidance will be associated with increased financial constraints and a greater risk of

financial distress.

In contrast, when the interests of managers and shareholders are properly aligned, efficient tax

management can provide a net positive value to the firm’s shareholders. If the marginal cost of

tax avoidance is sufficiently small, additional internal cash flows generated by tax avoidance may

reduce the firm’s financial constraints and the risk of financial distress.4Graham and Tucker

(2006) argue that tax planning using tax shelters is a value-enhancing activity that substitutes

for debt-induced tax deductions, which could enhance credit quality and reduce the cost of debt.

However, Desai and Dharmapala (2009) show a positive relation between firm value and tax

avoidance only within a subsample of well-governed firms.5Strong governance mechanisms

with properly structured managerial incentive schemes can ensure the positive value effect of

tax avoidance by disciplining the firm’s managers against managerial rent diversion and earnings

manipulation. Therefore, we predict that conditional on strong governance, greater tax avoidance

will not be associated with increased financial constraints.

We recognize that the causality of the relation between corporate tax avoidance and financial

constraints may operate in both directions. By focusing on the impact of corporate tax avoidance

on financial constraints, our study differs importantly from the prior literature that investigates

how financial constraints affect a firm’s tax avoidance behavior (Law and Mills, 2015; Edwards

et al., 2016). Because simultaneous causality may lead to biased ordinary least squares (OLS)

estimators, we conduct a two-staged least squares (2SLS) analysis with instrumental variables

to better identify the impact of tax avoidance on financial constraints conditional on governance

3Several high-profile corporate scandals at the turn of the century, such as Enron (see Desai and Dharmapala, 2009),

Dynegy (see Desai and Dharmapala, 2006), and Tyco(see Desai, 2005), involved tax avoidance, tax sheltering, earnings

manipulations, and accounting fraud or managerial theft. Desai, Dyck, and Zingales (2007) analyze the interaction

between corporate taxes and corporate governance, and how this interaction affects the level of managerial diversion.

Mironov (2013) shows that managerial diversioncauses a negative relation between tax evasion and firm performance.

4Mills (1998) finds that an additional $1 investment in tax planning results in a $4 reduction in tax liabilities.

5Minnick and Noga (2010) find that higher pay performance sensitivity provides better managerial incentives for tax

management that increases firm value.