When Short Seller Meets Government Stakeholder: The Case of Corporate Tax Avoidance

Abstract

This paper examines the effect of short selling on corporate tax avoidance. We propose a financial constraint view, that short selling triggers corporate insiders’ incentive to avoid taxes for funding investment opportunities in emerging markets. Employing staggered short-sale deregulation on the Chinese stock market as quasi-exogenous shocks, we find that the deregulation of short-sales reduces firms’ cash effective tax rates and effective tax rates by 11.8% and 21.1%, respectively. This effect is especially prominent for financially constrained firms and non-state-owned firms. We further show that short-sale deregulation indeed increases the cost of equity capital of Chinese listed firms. These results suggest that tax avoidance helps to generate additional funds and mitigates financial constraints under downward price pressure in emerging markets that have strong government intervention and lax law enforcement.