Effect of Tax Avoidance Activities on Firm-Specific Risk

Abstract

Does firm-specific risk increase as firms become more tax aggressive? Risky tax positions entail high probability that they will not be sustained upon examination, disallowing firms to claim benefits under these tax strategies and making it difficult for investors to predict firm’s future profitability. In this study, I find that idiosyncratic volatility, proxy for firm-specific risk, is negatively associated with effective tax rates. These results are robust to alternative variable definitions and model specifications. Results from two-stage least square regression and evidence from a natural experiment setting (implementation of FASB Interpretation No. 48) establish a direct and causal effect of tax aggressiveness on idiosyncratic volatility. The effect of risky tax strategies on idiosyncratic volatility lasts for long periods (up to seven years). Managerial risk aversion plays an important role in determining whether a firm will invest in risky tax strategies. Additional analyses show that the relation between firm-specific risk and tax aggressiveness is weaker when CEO ownership is high, and stronger when CEOs are compensated with options or when institutional ownership is high. The positive relation between tax aggressiveness and firm-specific risk is more pronounced for financially constrained firms, younger firms, firms that do not pay dividends, and technology firms.