Defend or remain quiet? Tax avoidance and the textual characteristics of the MD&A in annual reports

Abstract

Firms engage in tax avoidance (TA) for two reasons: to save funds or to manage agency conflicts. We hypothesize that if the motivation stems from agency conflicts, managers are likely to manipulate the text of annual reports to mask TA to preserve their private interests. In contrast, where firms engage in TA to save money, managers are likely to refrain from comment in the annual report because they have no incentives to defend their TA activities. Using a sample of Chinese firms and a textual analysis of the management discussion and analysis (MD&A) section of annual reports, we find robust evidence to support the agency conflict motives of TA. Specifically, we document that when a firm increases its TA, its MD&A is similar to that of its peers and to its previous annual report, and contains more tax-related key words. Further analysis shows that the impact of TA on tax-defensive behaviors is more salient for firms with small board size, less transparency, or low financial constraints. Last, we find that, conditional on a firm's TA activities, text manipulation in an MD&A alleviates the adverse impact of the TA on immediate- and short-term stock returns.