Corporate Tax Avoidance and High Powered Incentives

TLDR

The study examines how corporate tax avoidance is linked to the expansion of high‑powered managerial incentives. Using a simple model that captures feedback between tax sheltering and managerial diversion, the authors construct an empirical measure of tax avoidance (the book‑tax gap component unrelated to accruals) and test its relationship with incentive compensation. They find that higher incentive compensation reduces tax sheltering, especially in firms with weak governance, helping explain cross‑sectional variation, the undersheltering puzzle, and the association between large book‑tax gaps and subsequent negative abnormal returns.

Abstract

This paper analyzes the links between corporate tax avoidance and the growth of high-powered incentives for managers. We develop a simple model that highlights the role of feedback effects between tax sheltering and managerial diversion in determining how high-powered incentives influence tax sheltering decisions. Then, we construct an empirical measure of corporate tax avoidance - the component of the book-tax gap not attributable to accounting accruals - and investigate the link between this measure of tax avoidance and incentive compensation. We find that increases in incentive compensation tend to reduce the level of tax sheltering, in a manner consistent with a complementary relationship between diversion and sheltering. In addition, consistent with a prediction of our model, we find evidence suggesting that this negative effect is driven primarily by firms with relatively weak governance arrangements. Our results may help explain the growing cross-sectional variation among firms in their levels of tax avoidance, the "undersheltering puzzle," and why large book-tax gaps are associated with subsequent negative abnormal returns.