Equity Compensation and Tax Avoidance: Disentangling Managerial Incentives from Tax Benefits and Reexamining the Effect of Shareholder Rights

Abstract

Much empirical evidence is consistent with properly incentivized executives engaging in more tax avoidance. However, other studies provide evidence consistent with tax avoidance facilitating managerial rent extraction. We address these mixed results by reexamining some of the earliest empirical evidence that tax avoidance and rent extraction are complementary activities. Specifically, we reexamine the negative relation between executives’ equity compensation and tax avoidance that is concentrated in firms with weaker shareholder rights. Although this pattern of results is consistent with complementarities between tax avoidance and rent extraction, we propose it is also consistent with tax exhaustion theory because the substantial tax benefits from equity compensation reduce firms’ demand for additional tax avoidance. We also draw on recent findings that suggest shareholder rights indices are problematic as a measure of corporate governance in the context of tax avoidance. Our results suggest tax exhaustion is a more compelling explanation for cross-sectional differences in the relation between executives’ equity compensation and tax avoidance. Further, failing to control for tax avoidance opportunities when using shareholder rights indices can confound inferences. Although our analyses do not disprove the notion that managers can use tax avoidance to facilitate rent extraction, they challenge the notion that this behavior is widespread.