The Relation between Tax Risk and Firm Value: Evidence from the Luxembourg Tax Leaks

Abstract

We investigate the relation between tax risk and valuation of a firm’s tax avoidance through an analysis of the stock price reaction towards the firms that were exposed through the Luxembourg tax leaks. This event provides a unique opportunity to examine investors’ reaction to revelation of a firm’s specific tax avoidance strategies and the firm’s efforts to reduce the associated tax risks. Prior research investigating the relation of tax risk and firm value has depended on measures that could be compromised by firm reporting choices (e.g., uncertain tax benefit disclosures). The exogenous nature of the Luxembourg tax leaks provides an opportunity to better disentangle a firm’s actual tax risk from its “self-reported” tax risk. We find, on average, investors reacted positively to news of firms’ inclusion in the tax leaks. This is in contrast to the documented negative reaction to news of other tax shelter participation and the negative media and political reaction to the Luxembourg tax leaks. We attribute the difference in market reaction to information on firms’ preemptive steps to reduce the risk associated with their tax strategies by securing advance tax rulings. In cross-sectional analysis, we observe that among U.S. multinational firms, the market reacted more positively for those firms perceived to be less tax aggressive, as proxied by the firm’s cash effective tax rate. In addition, we find limited evidence of corporate governance explaining the variation in market reaction. We also fail to find empirical evidence of political or reputational costs explaining the variation in market reaction.