The effect of corporate tax avoidance on the cost of equity
Abstract
This paper examines the relation between tax avoidance and cost of equity. Based on the model developed by Lambert et al. (2007), we predict that tax avoidance can lead to a (i) higher cost of equity if investors perceive tax avoidance as involving complex transactions that increase firm opacity and facilitate managerial opportunistic rent-seeking, or (ii) lower cost of equity if cash savings from taxes can be redeployed to more productive uses and risk-neutral investors prefer risk-averse managers to engage in risky tax planning activities that create value. Our empirical results show that greater tax avoidance is associated with a lower cost of equity. Further analyses show that the effect is stronger for (i) firms with better outside monitoring, (ii) firms that likely realize higher marginal benefits from tax savings, and (iii) firms with better information quality. Our study presents large-sample results on how investors perceive corporate tax avoidance.