Does the Diversification of Tax Strategies Affect Tax Risk?

Abstract

I investigate the effect that the number of different tax strategies employed by a public company has on the relation between measures of corporate tax avoidance and measures of risk. Prior studies have generally failed to find a relation between measures of overall firm risk (such as stock return volatility) and measures of corporate tax avoidance (such as low effective tax rates). One possible reason for this empirical result is the failure to consider the role that the diversification of tax risk, through utilization of a portfolio of different tax avoidance strategies, might have on reducing tax risk and, as a result, on reducing overall firm risk. I create a broad measure of diversification based on five sources of tax benefits. Controlling for the level of tax avoidance, I regress measures of risk on diversification and an interaction term and find weak support that diversification reduces tax risk, as measured by the volatility of future cash ETRs, and mixed evidence on the effect of diversification on overall firm risk, as measured by the volatility of future monthly stock returns.