Corporate Tax Avoidance and the Level and Valuation of Firm Cash Holdings

Abstract

This paper examines the relation between corporate tax avoidance and firm cash holdings. Corporate tax avoidance limits payments made to the tax authorities. However, recent research notes that tax avoidance also restricts the flow of firm specific information and thereby exacerbates manager-shareholder conflict of interest. Specifically, it is argued that tax avoidance allows for greater rent extraction by managers. We examine this implication in relation to firm cash holdings. Cash is a fungible asset that can be easily diverted. To the extent that tax avoidance facilitates greater rent extraction, it will lead to a quicker dissipation of firm cash holdings. We empirically evaluate this prediction. To further evaluate the influence of tax avoidance, we also examine its impact on the valuation of firm cash holdings. If investors perceive tax avoidance as enabling diversion of firm resources, it should negatively impact their valuation of firm cash holdings. We provide three primary findings. First, we find a negative association between tax avoidance and firm cash holdings. We find this association to hold across multiple measures of tax avoidance. Second, we find this relation is attenuated for firms with stringent governance structures in place. This finding suggests stringent governance structures serve to limit the adverse effects of tax avoidance strategies. Finally, we find investor valuation of firm cash holdings is lower for firms with higher levels of tax avoidance. We again find this relation is attenuated for strong governance firms. Overall, our findings contribute to a growing stream of research which notes that tax avoidance is a double-edged sword which can cause more harm than good for shareholders.