Aggregate Corporate Tax Avoidance and Cost of Capital

Abstract

We identify a pecuniary externality arising from corporate tax avoidance. Firms share risk with the government via taxation. The lower the tax rate applied to a firm’s earnings, the more risk is borne by its shareholders. As more firms engage in avoidance in the aggregate, the variance of the market’s after-tax cash flow increases. Consequently, the covariance of a firm’s cash flow with the market cash flow, and thereby its cost of capital, increases. This occurs both for firms that avoid taxes and for those that do not. Consistent with our prediction, we find that firms’ implied cost of capital is positively related to aggregate corporate tax avoidance. This result holds not only for tax-avoiding but, crucially, also for non-tax-avoiding firms. As we predict, the pecuniary externality is stronger for firms whose cash flow covaries more with the market cash flow, and is driven by tax avoidance strategies that reduce a firm’s marginal tax rate as opposed to reducing its tax base.