Tax Avoidance and Dupont Measures of Future Performance

Abstract

To date, there is mixed evidence on the implications of tax avoidance on firm value as measured by Tobin’s q or stock price reactions. The take-away from prior literature is that increased opportunities for rent extraction associated with tax avoidance (e.g., in low governance firms), might negatively affect the after-tax value of the firm. We revisit this topic by investigating the association between tax avoidance and firm fundamentals (leverage, profitability, and asset utilization), using DuPont analysis. We document that tax avoidance unambiguously lowers future pretax accounting rates of return (i.e., return on equity, return on net operating assets, and return on operating assets), largely due to inefficient utilization of operating assets and operating liabilities. These results also hold in different contexts that mitigate rent extraction, including when firms have foreign operations and good governance.