Short selling and corporate tax avoidance: Insights from a financial constraint view

Abstract

While the traditional monitoring view suggests that short selling mitigates corporate tax avoidance, we propose and test a financial constraint hypothesis that short selling trigers corporate insiders' incentive to avoid taxes for funding investment opportunities. Employing staggered short-sale deregulation on the Chinese stock market as a series of quasi-exogenous shocks, we find that the deregulation of short sales significantly reduces firms' cash effective tax rates and effective tax rates. This effect is especially prominent for financially constrained firms and non-state-owned firms. These results suggest that tax avoidance helps to generate additional funds and mitigates financial constraints under downward price pressures. We argue that, in emerging markets with lax law enforcement and ineffective shelters from downside risk, short-sale deregulation induces firms to engage in more aggressive tax avoidance activities because avoiding taxes is cost-effective for them in mitigating the downward price pressure of short selling.