Corporate Governance and Tax Avoidance: Evidence from Governance Reform

Abstract

Prior literature struggles to find evidence in U.S. settings to support the Desai and Dharmapala (2006) theory on how corporate governance affects tax avoidance. Most studies rely on equity incentive compensation as their governance proxy. We use a Mexican setting to examine this association and find firms with stronger governance engage in less tax avoidance. We rely on both a hand-collected governance index and governance reform to show improved corporate governance pushes tax avoidance toward a new equilibrium. Supplementary analyses show associations between governance and tax avoidance are greatest for tax-cost-sensitive family-owned firms and non-cross-listed firms with naturally weaker governance. A one standard deviation increase in governance corresponds to an increase of between one and three percentage points in a firm’s effective tax rate. Our findings suggest these governance reforms effectively reduce rent extraction by majority shareholders and identify Board independence and audit committees as channels responsible for decreased tax avoidance.