Democracy and tax avoidance: An international study

• Author: Jiemin Yu,Kai Guo,Jiameng Ma
• Published date: 01 January 2020
• Date: 01 January 2020
• DOI: http://doi.org/10.1002/jcaf.22416

BLIND PEER REVIEW

Democracy and tax avoidance: An international study

Jiameng Ma

1†

| Kai Guo

2

| Jiemin Yu

3

1

School of Management, Shanghai

University, Shanghai, China

2

Business School, National University of

Singapore, Singapore

3

College of Civil Engineering, Tongji

University, Shanghai, China

Correspondence

Jiameng Ma, Assistant Professor, Shanghai

University, Baoshan District, Shanghai,

China.

Email: mjm8918@shu.edu.cn

Abstract

We examine the impact of home country democracy on corporate tax avoidance.

Specifically, we investigate how two aspects of democracy (political freedom and

electoral democracy) are associated with corporate tax avoidance, respectively.

Political freedom reduces tax avoidance, as public scrutiny increases financial

transparency risk of tax avoidance and participation in political decision-making

process raises willingness to pay taxes. Electoral democracy increases tax avoid-

ance, as election increases tax system complexity which in turn increases tax avoid-

ance. Furthermore, we find that corruption control and social stability strengthen

the negative association between political freedom and tax avoidance. Corporate

tax complexity as percentage of overall tax complexity strengthens the positive

association between electoral democracy and tax avoidance. Additional tests show

shareholder protection and being a common law country weaken the negative asso-

ciation between political freedom and tax avoidance, and strengthen the positive

association between electoral democracy and tax avoidance. Robustness checks

using colony history as instrumental variable confirm the results.

1|INTRODUCTION

We examine the impact of home country democracy on

corporate tax avoidance. Specifically, we investigate how

two aspects of democracy (political freedom and electoral

democracy) are associated with corporate tax avoidance,

respectively. We show that political freedom reduces

tax avoidance, while electoral democracy increases tax

avoidance.

Following Atwood, Drake, Myers, and Myers (2012), we

define the home country as the country where the parent com-

pany is incorporated and where all repatriated earnings are

included. Tax paid is the last layer of tax before dividend.

Hanlon and Heitzman (2010) define tax-planning strategies as

a continuum where perfectly legal and low-risk tax avoidance

is at one end and illegal tax evasion at the other. This paper is

particularly interested in the legal end of tax avoidance.

This paper is motived by the following three aspects.

First, we are answering the call for more research on factors

influencing tax avoidance (Dyreng, Hanlon, & Maydew,

2008; Graham, 2003; Hanlon & Heitzman, 2010;

Shackelford & Shevlin, 2001). Nowadays listed firms

avoid huge amount of taxes. For the United States, taxes

avoided by the largest 50 US firms from 2008 to 2014 is

over 300 billion US dollars, which is several times of some

countries' gross domestic products (GDP). For the United

Kingdom, one in four biggest 100 listed firms pay no cor-

porate tax in 2012 and almost half fail to disclose their tax

payments to the United Kingdom at all. Therefore, we

examine one additional determinant of tax avoidance to

add to the understanding of firms' utility function in tax

strategy.

Second, among all the studies on determinants of tax

avoidance, most of them are at firm level, while less is

understood about macro-level factors. Only one paper by

Atwood et al. (2012) studies how tax system characteristics

affect tax avoidance. This research is motivated by this void

of macro-level factors and hopes to fill the void.

Our third motivation explains the reason why we exam-

ine democracy among all the macro-level factors. Jennings,

†

Jiameng Ma thanks the funding of Shanghai Pujiang Talents Plan

Received: 4 July 2019 Accepted: 11 September 2019

DOI: 10.1002/jcaf.22416

18 © 2019 Wiley Periodicals, Inc. J Corp Acct Fin. 2020;31:18–52.wileyonlinelibrary.com/journal/jcaf

Weaver, and Maydew (2012) call for more studies on the

understanding of implicit taxes, as implicit taxes is an impor-

tant public policy issue. We show that electoral democracy

is one kind of implicit taxes. Firms that pay for the election

of government and legislation are exempted in taxes. The

campaign contributions for elections are implicit taxes.

It is important to understand how home country democ-

racy and its various aspects affect tax compliance, because

the implications for investors in global markets. Hanlon and

Heitzman (2010) find that tax expense information in finan-

cial statements contains information about current and future

earnings. Therefore, knowledge of a country's political insti-

tution and its various aspects of democracy will help inves-

tors better predict firms' tax compliance in the country and

then their earnings as well.

We identify two perspectives that have heterogeneous

effects on tax avoidance: (a) political freedom: participation

of citizens in politics and civic life, and (b) electoral democ-

racy: a system for choosing and replacing a government

through free and fair elections. (a) For political freedom, we

expect a negative association with tax avoidance. Tax avoid-

ance entails financial transparency cost. Tax planning

increases organizational complexity and reduces financial

transparency. Political freedom is associated with public

scrutiny and easy outcry of opinion. In countries where there

is more political freedom, public scrutiny and media free-

dom result in higher financial transparency risks of corporate

tax avoidance, thus increase the cost. Therefore, political

freedom is negatively associated with tax avoidance. (b) In

electoral democracy, voters have heterogeneous interests

and preferences. Government policies are adopted for the

benefits of the politicians to win the elections and maximize

the number of voters. Theories show that tax system will be

complex under such electoral democracy to cater to each

and every voter's preference and to maximize support from

voters. Tax complexity leads to more tax avoidance as vari-

ous tax rates, bases and provisions make it hard even for the

government to perfectly determine taxpayers' true tax liabili-

ties. And taxpayer will also intentionally take advantage of

the various provisions to minimize their tax payments.

Using a sample of 53,098 firm-year observations from

33 countries and from 2008 to 2014, we examine the associ-

ation between two aspects of democracy and tax avoidance.

We follow democracy measures by the Economist Intelli-

gence Unit. We adopt its two indexes of political participa-

tion and political culture to proxy for political freedom. We

utilize its two indexes of electoral process and pluralism,

and functioning of government to proxy for electoral democ-

racy. As predicted, we find that political participation and

political culture are negatively associated with tax avoid-

ance. Electoral process and pluralism, and functioning of

government are positively associated with tax avoidance.

Furthermore, we find that corruption control and social sta-

bility strengthen the negative association between political

freedom and tax avoidance. Corporate tax complexity as per-

centage of overall tax complexity strengthens the positive

association between electoral democracy and tax avoidance.

We also show that after combining the two perspectives of

democracy together, the net effect is positive. This suggests

that the positive association between electoral democracy

and tax avoidance dominates. In addition, we consider the

role of corporate governance by investigating the moderating

effect of shareholder protection and legal system. We find

that shareholder protection and being a common law country

weaken the negative association between political freedom

and tax avoidance, and strengthen the positive association

between electoral democracy and tax avoidance. Robustness

checks using colony history as instrumental variable confirm

the negative (positive) association between political freedom

(electoral democracy) and tax avoidance.

We contribute to the literature in several ways. First, we

add to the literature of tax avoidance. Prior studies show that

tax avoidance is determined by many firm level factors such

as the effects of executives, CEO compensation, dual-class

ownership, auditor-provided tax services, internal informa-

tion environment, financial derivatives, hedge fund activism,

corporate governance, corporate social responsibility, prod-

uct market power, tax specific industry expertise, and labor

union (Armstrong, Blouin, Jagolinzer, & Larcker, 2015;

Cheng, Huang, Li, & Stanfield, 2012; Chyz, Leung, Li, &

Rui, 2013; Donohoe, 2015; Dyreng, Hanlon, & Maydew,

2010; Gaertner, 2014; Gallemore & Labro, 2014; Hogan &

Noga, 2015; Hoi, Wu, & Zhang, 2013; Kubick, Lynch,

Mayberry, & Omer, 2015; McGuire, Omer, & Wang, 2012;

McGuire, Wang, & Wilson, 2014). Prior researches focus on

firms within a single country and micro level determinants.

We extend the literature by examining cross-country varia-

tion in and macro-level factors of tax avoidance. We add to

another cross-country study that investigates the association

between home country tax system characteristics and tax

avoidance by Atwood et al. (2012).

Second, we add to the literature of political connections

and firms' economic outcomes. Prior studies have docu-

mented how connections with politicians affect economic

outcomes indirectly via the change in general institutional

environment (Morck, Wolfenzon, & Yeung, 2005; Rajan &

Zingales, 2003). For example, incumbents may introduce

more competition to control financial development (Rajan &

Zingales, 2003). Prior researches also show that connections

with politicians have direct effect on economic outcomes at

firm level. Political connections help firms have easier

access to finance (Claessens, Feijen, & Laeven, 2008;

Khwaja & Mian, 2005). Politically connected firms are more

likely to win government procurement contracts (Goldman,

MA ET AL.19

Rocholl, & So, 2013). The effect on firm value, however, is

mixed (Cooper, Gulen, & Ovtchinnikov, 2010; Fisman,

2001). Empirical studies document both positive and nega-

tive associations. This study contributes to the literature by

showing another direct effect at firm level, which is tax

avoidance.

Third, we add to the literature of corporate governance

and tax avoidance. Prior studies show mixed and inconclu-

sive evidence. One strand of literature (Cheng et al., 2012;

Minnick & Noga, 2010; Rego & Wilson, 2012) argues that

tax avoidance is one of many risky investment opportunities

available to management. Similar to other investment deci-

sions, agency problems lead managers to select a level of tax

avoidance that is suboptimal. Rather, as with other agency

problems, various governance mechanisms help mitigate

agency problems of tax avoidance. Therefore, corporate gov-

ernance is positively associated with tax avoidance. How-

ever, the other strand (Desai & Dharmapala, 2006) argues

that tax avoidance is associated with operational complexity

and opaque internal information environment, which in turn

increases the opportunity for managers to use firm resources

to pursue their private interests. Avoiding tax avoidance

strategies can lower managerial entrenchment. Therefore,

corporate governance mechanisms lower tax avoidance. We

show results consistent with the first strand of literature. We

find that corporate governance strengthens the positive asso-

ciation between electoral democracy and tax avoidance, and

weakens the negative association between political freedom

and tax avoidance.

The remainder of the paper proceeds as follows:

Section 2 reviews the literature and develops hypothesis.

Section 3 describes sample, variables, and research design.

Section 4 presents descriptive statistics and results. Section 5

discusses results of the role of corruption control, political

stability and tax complexity. Section 6 discusses results of

the role of corporate governance. Section 7 shows overall

democracy effect and robustness checks. Section 8

concludes.

2|RELATED LITERATURE AND

HYPOTHESIS DEVELOPMENT

Democracy is a broad concept. Freedom House, a US-based

organization famous for its research and advocacy on

democracy, identifies two perspectives: (a) political free-

dom: participation of citizens in politics and civic life, and

(b) electoral democracy: a system for choosing and replacing

a government through free and fair elections. We discuss the

associations between the two perspectives and tax avoidance

separately. The definition of tax avoidance follows that in

Hanlon and Heitzman (2010) and Atwood et al. (2012). It is

the reduction of explicit taxes. This definition includes all

tax reduction strategies, either legal or illegal,

1

and with per-

manent or temporary book-tax differences or without any

book-tax differences.

2.1 |Political freedom and tax avoidance

2.1.1 |Financial transparency and tax

avoidance

All tax planning strategies increase organizational complex-

ity (Balakrishnan, Blouin, & Guay, 2019). This may be cau-

sed by creation of entities or subsidiaries in tax heavens,

merger and acquisitions for tax planning purpose and capital

loss utilization. Organizational complexity can result in

investors' difficulty in understanding the firm and lower

financial transparency (Bushman, Chen, Engel, & Smith,

2004). Therefore, the expected benefits of tax avoidance do

not come without costs, and one of them is financial trans-

parency cost (Kim & Zhang, 2016).

Political freedom allows public participation in political

process and freedom in expression of opinions (Hasbach,

1915; Milton, 1936; Olson, 1993; Turner, 1923). Such

involvement in social affairs reduces information asymmetry

and increases requirement of transparency, whether in public

governance or corporate governance (May, 1965). There-

fore, political freedom increases the financial transparency

cost of tax avoidance. We propose that political freedom is

negatively associated with tax avoidance.

2.1.2 |Tax morale and avoidance

In the studies on legitimacy and compliance decisions, Tyler

(1990a, 1990b) shows that if people regard authorities as

more legitimate they are more likely to comply with the

rules. Tyler, Casper, and Fisher (1989) argue that how

authorities treat the people affects the people's evaluation of

authorities' legitimacy and therefore people's willingness to

cooperate. Having knowledge of what the people want

increases satisfaction with the rules and builds public sup-

ports for legal procedures. Cialdini (1989) and Kidder and

McEwen (1989) find that the more people are involved in

establishing rules, the stronger their sense of obligation and

the less likely non-compliance occurs. Freedom of partici-

pation in the political decision-making process not only

improves the satisfaction with the system, but also creates

a sense of civic duty and thus enhances the morale in

obedience.

The above argument applies to tax law and compliance

as well. Frey and Stutzer (2002) and Torgler (2002) docu-

ment that freedom of participation enables taxpayers to

influence the tax law indirectly or directly. Such a role

reduces information asymmetry between the people and the

government and helps the taxpayers to monitor and control

20 MA ET AL.