Cost of Tax Avoidance: Examining the Role of Product Market Structure

Abstract

Examining product market structure, we show that market leaders engage in greater levels of all forms of tax planning and generate more sustainable tax positions. Importantly, examining cost of equity capital we document asymmetrical benefits to tax avoidance for market leaders in that while they participate in benefits to tax optimization, unlike the case for non-leader firms, they are shielded from additional risk premiums required for more aggressive levels and forms of tax avoidance. Realized tax risk, however, has economically meaningful effect on investors’ perception of overall firm risk regardless of market power. Moreover, we confirm the findings in Cook et al. (2015) that at low/(high) levels of tax avoidance investors outweigh benefits/(incremental risks) of tax optimization/(avoidance). Overall, our analysis validate arguments that there exists negligible ex-ante costs to tax avoidance particularly for firms with significant market power. These results are robust to linear vs non-linear modelling assumptions, returns-based models, post-FAS109 period estimates and to measures of income mobility, financial constraints and corporate governance.