Taxes and Corporate Policies: Evidence from a Quasi Natural Experiment

• Date: 01 February 2015
• Published date: 01 February 2015
• DOI: http://doi.org/10.1111/jofi.12101
• Author: ALEXANDER DYCK,CRAIG DOIDGE

THE JOURNAL OF FINANCE •VOL. LXX, NO. 1 •FEBRUARY 2015

Taxes and Corporate Policies: Evidence from

a Quasi Natural Experiment

CRAIG DOIDGE and ALEXANDER DYCK∗

ABSTRACT

We document important interactions between tax incentives and corporate policies

using a “quasi natural experiment” provided by a surprise announcement that im-

posed corporate taxes on a group of Canadian publicly traded firms. The announce-

ment caused a dramatic decrease in value. Prospective tax shields partially offset

the losses, adding 4.6% to firm value on average, and vary with the tax status of the

marginal investor. Further,firms adjust leverage, payout, cash holdings, and invest-

ment in response to changing tax incentives. Overall, the event study and time series

evidence supports the view that taxes are important for corporate decision making.

HOW DO CORPORATE POLICIES interact with tax incentives, and do managers

make significant changes to corporate policies in response to a change in

taxes? While a large literature examines taxes and corporate policies and much

progress has been made, Fama (2011) argues that the big open challenge in

corporate finance remains to produce evidence on how taxes affect market

values and thus optimal financing decisions. Stewart Myers injects further

skepticism, stating that taxes are of “third order” importance for corporate

decision-making (Myers et al. (1998)).

One reason the empirical challenge remains is that tax effects are difficult to

document. Cross-sectional tests face identification challenges while tests based

on tax policy changes are limited because such changes are rarely significant or

separable from other changes and are often widely anticipated. Consequently,

results may be not be economically significant or may be open to multiple

interpretations. Without a sizable and unambiguous change in tax policy, it is

∗Craig Doidge and Alexander Dyck are with the Rotman School of Management, University of

Toronto. Special thanks to Laurence Booth for many helpful comments and discussions. Warren

Bailey,Susan Christoffersen, Sergei Davydenko, James Hines, Jan Jindra, Inmoo Lee, Jan Mahrt-

Smith, Lukasz Pomorski, Kent Womack, the Editor Cam Harvey, the Coeditor John Graham, two

anonymous referees, and an Associate Editor provided many helpful comments and suggestions,

as did seminar participants at HEC Paris, Nova University Lisbon, Tilburg University,University

of Mannheim, the University of Toronto, the University of Toronto Law School, the 2011 Korea

American Finance Association/Korea Capital Market Institute conference, and the 2012 American

Finance Association conference. Wethank John Rule for providing access to institutional ownership

data from www.targeted.ca. Doidge thanks the Social Sciences and Humanities Research Council

of Canada for financial support. Dyck thanks INSEAD for hosting him as a visiting scholar while

part of this research was completed. Feng Chi, Aazam Virani, and Xiaofei Zhao provided excellent

research assistance.

DOI: 10.1111/jofi.12101

45

46 The Journal of Finance R

also difficult to examine the impact on a range of interrelated corporate policies,

which, as Graham (2003) suggests, offers significant potential to separate tax

from nontax interpretations.

In this paper, we exploit a “quasi natural experiment” provided by a change

in tax policy to identify a statistically and economically significant impact of

taxes on corporate policies. Unlike many tax policy changes analyzed in prior

literature (e.g., the Tax Reform Act of 1986), the tax change we exploit was

largely unanticipated, dramatic (the corporate tax rate increased from 0% to

31.5%), and was not contaminated by other information or policy changes.

We provide new market-based evidence on the value of tax shields and the

extent to which taxes reduce firm value, and we show that there are signifi-

cant changes in corporate policies in response to the tax change. Because we

document changes in valuations and in several intertwined corporate policies,

our evidence is supportive of the view that taxes are important for corporate

finance.

The tax policy change we exploit is officially known as the Tax Fairness Plan

(TFP) but is unofficially referred to as the “Halloween Massacre” because it

took place after markets closed on October 31, 2006. The TFP affected a large

number of publicly traded Canadian firms called income trusts. Prior to the

TFP, firms that adopted the income trust structure could avoid paying almost

all corporate taxes while retaining the advantages of the corporate structure.

The trust structure, which arguably had no nontax rationale (Edgar (2004)),

allowed trusts to pass all income through to investors who were then taxed at

the personal level. In the early 2000s, the Canadian equity market was trans-

formed as trusts became an increasingly important part of the market. Es-

tablished publicly traded corporations from a broad cross-section of industries

converted to the trust structure and new firms went public as trusts, account-

ing for almost 70% of IPO proceeds raised from 2001 until the announcement

of the TFP in 2006. Including publicly traded corporations that had announced

plans to convert to the trust structure but had not yet completed the conver-

sion, at its peak the trust market was worth $253 billion (Canadian dollars),

almost 13% of the total value of the Toronto Stock Exchange (TSX).

The TFP eliminated the tax advantage of the income trust structure. It im-

posed a tax rate equivalent to that levied on corporations on all new trusts

while existing trusts were allowed a four-year transition period. Importantly,

the TFP did not contain any other major reforms or information about trusts.

The plan to tax trusts broke a key election promise of the newly elected Con-

servative government and the announcement was a surprise to the market

(see Figure 1). Reuters News reported that “Canada stuns market with pledge

to tax income trusts” while Canada’s leading business newspaper, The Globe

and Mail, proclaimed that “Ottawa’s tax surprise sends investment bankers

scrambling, investors fleeing, stock prices plunging.”1

1See Reuters News, October 31, 2006, and The Globe and Mail, November 1, 2006, page B1. A

Factiva search reveals that, from the election of the Conservative government in January 2006

through September 2006, there was no discussion in the press that indicated market participants

Taxes and Corporate Policies 47

-30%

-20%

-10%

0%

10%

20%

30%

26-Sep

29-Sep

4-Oct

10-Oct

13-Oct

18-Oct

23-Oct

26-Oct

31-Oct

3-Nov

8-Nov

13-Nov

16-Nov

21-Nov

24-Nov

29-Nov

4-Dec

7-Dec

12-Dec

15-Dec

20-Dec

27-Dec

Returns

Date

All trusts excluding REITS REITS Corporates

Figure 1. Returns around the Tax FairnessPlan announcement. This figure shows cumu-

lative abnormal returns on portfolios of trusts and REITs (Real Estate Investment Trusts) from

September 26 to December 29, 2006 (days −25 to +40 around the October 31 announcement). It

also shows cumulative returns on a value-weighted portfolio of corporates. To compute abnormal

returns, the regression Rpt =α+βm×Rbt +β´i×Rind t +γ´×Event +εtis estimated from

July 1, 2005, to December 31, 2006. Event is a vector that includes dummy variables for the event

days, where November 1, 2006, is Day 0. Rpis the daily return on a value-weighted portfolio that

includes all trusts (includes pending trusts but excludes REITs and U.S.-based trusts that were

listed on the TSX via IPSs or IDSs) or on a value-weighted portfolio of REITs. Rbis the daily

return on the value-weighted benchmark portfolio and Rind is a vector that includes the daily

returns on five value-weighted industry portfolios based on the Fama-French five industry classifi-

cations. The benchmark and industry portfolios include corporates that have total assets of at least

$10 million and trade on at least 40% of the trading days in a given year.

The price reactions from this quasi natural experiment have been docu-

mented by others, including Elayan et al. (2009) and Edwards and Shevlin

(2011). Elayan et al. focus on the role of tax clienteles to explain the varia-

tion in price reactions and to test theories about dividend policy. Edwards and

expected a tax policy change. In September and October 2006, two major telecommunications

firms, Telus and BCE, announced plans to convert to the trust structure. Following the BCE

announcement on October 11, some market commentators wondered whether the government

would be forced to review the trust structure. However, none expected any action in the immediate

future, noting the high political costs (see, e.g., “Expert sees no change in income trust law: Despite

costing $1B a year, Tories unlikely to act,” The Ottawa Citizen, October 27, 2006). From the BCE

announcement through October 31, returns in the trust market were 6.2% compared to 6.6% for

the overall market.