Tax Avoidance and Equity Pricing: The Importance of Countries’ Legal Institutions and Disclosure Regulations

Abstract

Building on Desai and Dharmapala’s (2006) complementarity theory on the relation between tax avoidance and insider diversion, we contribute to international research by examining the importance of tax avoidance to equity pricing, and the role that institutional environments play in shaping this link. Our theoretical framework generates two predictions. First, investors require higher risk premium compensation for their exposure to insiders’ diversion of corporate resources hidden by obfuscatory tax avoidance activities. Second, stronger country-level legal institutions and disclosure regulations mitigate this impact. Analyzing a sample of firms from 47 non-U.S. countries, we report strong evidence that equity financing costs rise when firms take more aggressive tax positions. Additional analysis implies that stricter investor protection institutions and disclosure regulations alleviate investors’ concerns about insider diversion, moderating the positive impact of tax avoidance on equity pricing. The results are robust to specifying alternative measures of tax avoidance and equity financing costs, as well as to addressing endogeneity. Collectively, these findings suggest that investors recognize the complementarity between insider diversion and tax avoidance in less protective environments. Our evidence has major implications for investors and policy makers.