Customer Concentration and Corporate Tax Avoidance

Abstract

We examine the relation between customer concentration, a critically important aspect of a firm’s business model, and the level of corporate tax avoidance. A firm with a concentrated corporate customer base needs to hold more cash, faces a higher likelihood of financial distress, has a stronger incentive to manage earnings upwards, and is likely to be more risk tolerant. Since tax planning can increase both cash flow and accounting earnings and risk tolerant firms are more likely to accept the risks inherent in tax avoidance activities, we hypothesize that corporate customer concentration is positively associated with tax avoidance. As predicted, we find that various measures of corporate customer concentration are positively related to tax avoidance as measured by effective tax rate and book-tax difference. We also document that this positive relation is more pronounced when the firm captures a lower market share in its industry, enjoys less revenue diversification, and engages in less real earnings management. By contrast, we contend that a governmental major customer provides stable cash flow to suppliers and thus alleviates their need for tax avoidance. Consistent with this reasoning, we find that firms engage in lower levels of tax avoidance when they have a governmental major customer, and this association is less pronounced under Democratic presidencies. Together, our findings indicate that a firm’s business model (i.e., corporate and governmental major customer) has a significant effect on the extent to which it avoids taxes.