The effect of corporate tax avoidance on investments, and its relationship to firm liquidity

Abstract

Despite decades of tax and investment research, little is known about the relationship between a firm's ability to avoid income taxes and its level of investments. For instance, several researchers conclude that firms’ investment decisions are sensitive to cash flow variations. However, there is to our knowledge conducted little or no research on the relationship between liquidity and investment-sensitivity in relation to tax avoidance. The purpose of this study is to shed some initial evidence on these questions, and provide new valuable insight to both future and previous research on a frequently discussed topic. Using firm-level panel data, we find both statistically and economically significant evidence of that investments is positively related to the cash flow effect of tax avoidance. We also find that higher liquidity firms tend to invest more and companies classified as “good liquidity firms” seem to have a greater investment sensitivity towards changes in the effective tax rate. We strive to impose minimal requirements on our sample to maximize our coverage. Hence, our sample includes both listed and unlisted Norwegian companies for the 2006-2015 fiscal years. With respect to available data on each company's cash flow statement, including unlisted companies has its shortcomings. Since our dataset does not have a direct measure of investment or capital expenditures, we define three alternative Investment measures to ensure the robustness of our results. Further, tax avoidance is measured as the level of effective tax rates relative to pretax income. As in Dyreng et al. 2008, we define tax avoidance broadly to encompass anything that reduces the firm’s taxes relative to its pretax accounting income. All our results are thoroughly tested to ensure the robustness of our findings.