Tax Avoidance, Corporate Governance

and Firm Value

Jingjing Chen1

This paper examines whether corporate governance regulates the influence of tax

avoidance on firm value and how this influence affects the valuation of shareholders.

Taking the data of FTSE 350 firms on London Stock Exchange from 2008 to 2015 as

the sample, the empirical results show evidence that the effect of tax avoidance is

positive on firm value for firms with strong corporate governance and insignificant for

firms with weak corporate governance. Among the corporate governance techniques,

compensation incentives and board structure appear to have impacts on corporate tax

avoidance and other proxies of corporate governance show no statistical significance

on tax avoidance measures. As shown in the findings, the relationship between

corporate tax avoidance and firm value is found to be conditional to corporate

governance at disaggregate level and the overall effect of corporate governance on the

relationship is insignificant.

Keywords: Tax Avoidance; Corporate Governance; Firm Value; Agency theory;

1 Jingjing Chen (jingjing.chen@wsu.edu) is a PhD student of Finance and Management Science Department, Carson College of Business, Washington State University in Pullman, WA.

1. Introduction

This study aims to examine the relationship between tax avoidance, corporate

governance and firm value in a sample of UK companies. The research puts forward

two fundamental questions, how shareholders consider the value of corporate tax

avoidance activities, and to what extent corporate governance affects the shareholder’s

valuation on tax avoidance. From a traditional point of view, in other words, in the

absent of agency costs, corporate tax avoidance activities impose both costs and

benefits. With a nature of minimizing the tax liability of a company, tax avoidance

activities arguably transfer the state wealth to shareholders’ value. In terms of costs of

tax avoidance activities, there are direct costs regarding resources used to engage in

such activities, and potential costs of market scrutiny and reputation damages (Desai

and Dharmapala 2009). The trade-off between potential costs and benefits of tax

avoidance results in an uncertain effect of corporate tax avoidance on firm value.

Furthermore, agency theory considers managerial tax avoidance actions as possible

opportunities for managers to pursue self-interests (Desai and Dharmapala 2006).

Would the effect of agency costs be significant enough to reveal a loss of firm value?

Under the agency framework, corporate governance is relevant to mitigate such effect

of managerial diversion. Desai and Dharmapala (2009) further propose that the benefits

of tax avoidance activities in saving tax charges are possibly offset by the potential

managerial rent extraction for firms with weak corporate governance. Therefore, such

benefits and the net effect of tax avoidance are likely to be greater for firms with

stronger corporate governance.

Tax management generally refers to the activities that reduce firm’s tax liability. This

broad definition presents a continuum of which one end is perfectly legal activities as

strategic tax planning and the other extreme is illegal tax evasion (Dyreng et al. 2008;

Hanlon and Heitzman2010). To avoid distinguishing the legality of tax-reduction

activities, tax avoidance activities are those strategies between the two extremes of tax

management (Hanlon and Heitzman 2010). Definition of tax avoidance from tax

authority is relatively narrower, for instance, HMRC (2015) refers to tax avoidance as

gaining tax advantages in an unintended way of the law. The interest of tax authority is

more likely about estimating and tackling the tax gap rather than maximizing

shareholder wealth or reconciling principle-agent problems. The question, which part

of the continuum does tax avoidance activities fall in, depends on the aggressiveness of

tax management activities. The interest of prior research is intentional tax reduction

strategies at the aggressive extreme of the continuum. This research also focuses on the

aggressive end of tax management and defines tax avoidance following Hanlon and

Heitzman (2010) and Slemrod (2004) as a subset of tax management activities which

is to pay lower taxes by engaging in a wide range of transactions without an actual

response by the company.

The practices of corporate tax-related behaviours closely link to changes in tax regime

and the attitude of managers, shareholders and the general public with regards to tax

responsibility. According to the survey of KPMG (2016), 75% of companies respond

that a country’s tax system is the main reason that drives the choice of where to locate

the corporation. Compared to international peers, the UK has recently been considered

as a considerably attractive destination of business activities due to its competitiveness

of tax system (KPMG 2016). The competitiveness arises from the stability of the regime,

forewarning of big changes and simplicity resulting from previous tax reform. The UK

corporate tax rate has been reduced steadily since 1982 with a peak of 52% to 2016

with 20% as the lowest rate among G82 (Brooks et al. 2016). The environment in the

UK has recently shown a changing attitude towards corporate tax avoidance activities.

Some practices of tax avoidance become unacceptable by the general public(Brooks et

al. 2016). After a few years of calling for increased tax transparency and responsibility,

companies are responding along with improved transparent reports of tax affairs

(KPMG 2016). In terms of corporate tax-related activities, the study of UK firms

reflects the respond to a stable and well-developed tax regime.

The Recent publication of corporate “tax gap” 3 from HM revenue and Customs

(HMRC) is estimated to be £3.0 billion for 2013-2014, which compromises seven

percent of the estimated corporate tax liability. According to the report, the tax gap of

Large Business Service Corporation (LBS), which is £1.0 billion for 2013-14, £1.1

billion for 2012-13 and 2011-12, and £1.8 billion for 2010-11, could be attributed to

“avoidance risks” with 80%, 82% and 83% respectively. Although the tax gap of

corporate income tax has shown a reduction over the period of 2005-06 to 2013-14, the

interest and behaviour of reducing tax payment remain active.

Prior literature has long-standing interests on the tax effect of real corporate financial

decisions, such as tax effect on capital structure, dividend policy, compensation policy,

risk management, and organizational forms (Graham 2003). Instead of taking taxes as

one of the determinants of those decisions, could tax itself possibly be a decision of a

company? The answer to the question attracts attentions to corporate tax avoidance

activities. How tax avoidance decisions, which relates to reducing corporate tax liability,

affect firm value and cost of debts 4 , and could corporate governance mitigate or

encourage tax avoidance?

US research presents empirical results more in line with the notion of Desai and

Dharmapala (2006) agency framework. Cloyd et al. (2003), Hanlon and Slemrod (2009)

and Kim et al. (2011) find strong evidence suggesting that the market reaction to tax

avoidance activities is negative. Kim et al. (2011) also document that well-

governance firms tend to have greater net effect of tax avoidance resulting in an

increased firm value, consistent with the findings of Huseynov and Klamm (2012) using

Cash ETR. However, the results of empirical research seem to be sensitive to tax

avoidance measures and corporate governance quality. Desai and Dharmapala (2009)

fail to find a significant relationship between book-tax difference (BTD) and firm value

at an aggregate level which implies that the average effect of tax avoidance on firm

value could also be offset.

Recent UK study by Brooks et al. (2016) shows evidence that no negative or significant

relationship has been found between corporate tax payment and financial performance.

The study of Brooks et al. (2016) investigates the price reaction to tax rate changes by

2 Noted that Russia, which is currently suspended as a G8 member, also has a 20% corporate tax rate. 3 The “tax gap” is defined in the HMRC (2015) report as the difference between theoretical tax liability and the amount of tax which is actually collected. 4 Despite firm value, another influences of tax avoidance is on the cost of debts. Beck et al. (2014) argue that corporate tax avoidance, particularly illegal tax evasion activities, have been accused of being an important cause of sovereign debt crisis since they cause fiscal instability. The examination of tax avoidance could contribute to resolving the asymmetric information problem between shareholders and managers in the process of financial crisis (Beck et al. 2014).

using long-term ETRs during 1988 to 2014. In contrast, Abdul Wahab and Holland

(2012) find UK evidence consistent with the notion of agency framework on tax

avoidance that tax planning is negatively associated with the market value of equity,

but no evidence is found that corporate governance plays a role in mitigating the

relationship. They show that permanent book and tax difference is the component that

shapes the negative relationship.

Other studies further investigate which of the corporate governance techniques

influence corporate tax avoidance behaviour. Dyreng et al. (2010) show that individual

executives have a significant impact on the aggressiveness of tax avoidance level. Lanis

and Richardson (2011) find that the proportion of independent directors on the board

lowers the possibility of engaging in aggressive tax avoidance activities. Kubick and

Lockhart (2016) show strong evidence that incentives of the external labour market,

which motivates directors to be competitive for their employment position, is important

in determining the corporate aggressive tax strategies. By using various proxies to

examine the role of corporate governance mechanisms in tax avoidance activities,

Minnick and Noga (2010) find that compared to incentive compensation, especially

pay-performance-sensitivity, other corporate governance measures have less impact on

tax avoidance. They also document that tax avoidance with better corporate governance

results in higher returns for shareholders. Instead of using various proxies to measure

the corporate tax avoidance levels, Armstrong et al. (2015) use quantile regressions

associated with the extreme levels of tax avoidance distribution to examine the potential

shifts in the relation of tax avoidance in condition to different corporate governance

techniques. They find that board independence and financial sophistication could

mitigate the agency problem but high equity incentives increase the risk of moral hazard

by managers, consistent with the findings of Rego and Wilson (2012).

This paper contributes in the following. First, it provides UK evidence with regard to

shareholders’ valuation on tax avoidance of companies under UK tax regime. Second,

this research advances the knowledge of the effect of corporate governance on the

relationship between tax avoidance behaviours and firm value under agency framework.

Third, this paper employs various proxies of tax avoidance and corporate governance

and jointly examines the validity and reliability of those measures. Fourth, the

discussion of the interplay between corporate governance and tax avoidance may shed

light on the fundamental question whether better corporate governance techniques

result in increasing firm value (Minnick and Noga 2010). Fifth, the analysis is based on

a period of eight years and reflects the changing attitudes of tax avoidance over time.

In summary, the regression results show evidence that there is no significant

relationship between tax avoidance and firm value. The relationship between corporate

tax avoidance and firm value is found to be conditional to the level of corporate

governance at disaggregate level. The effect of tax avoidance is positive on firm value

for firms with strong corporate governance and insignificant for firms with weak

corporate governance. The results are consistent with the hypothesis that corporate

governance moderates the principle-agent problem. Among those corporate governance

techniques that have been examined, compensation incentives and board structure

appear to have impacts on corporate tax avoidance and other proxies of corporate

governance show no statistical significance on tax avoidance measures.

The remainder of the paper is structured as follows. Section 2 explores the underlying

theories and empirical evidence as well as develops the hypotheses for the relation

between tax avoidance, corporate governance and firm value. Section 3 discusses the

models used to test the hypotheses and the choices and measurement of key variables.

Section 4 describes the process of data collection and summary statistics of the sample.

Section 5 analyses the empirical results. Section 6 concludes and acknowledges the

limitations of the research.

2. Literature review and hypotheses development

There is a young and growing literature studying the effect of corporate governance on

tax avoidance and firm value. Hanlon and Heitzman (2010) argue that it would be hard

to determine the legality in advance of the fact of tax avoidance activities. The legal

ambiguity of tax avoidance strategies provides a ground for agency framework to

perceive tax avoidance as a risky investment which contains both positive potentials

and negative damages on firms. The following section gives a general review of the

recent stream of the related literature and discusses how corporate governance

mechanism influences the relationship between tax avoidance and firm value. Section

2.1 explains the fundamental framework of corporate governance, tax avoidance, and

firm value. Section 2.2 reviews the previous literature on tax avoidance and firm value.

Section 2.3 discusses empirical evidence regarding different corporate governance

characteristics relating to tax avoidance activities. Section 2.4 develops the control

variables included in regression analysis. Section 2.5 emphasizes on the measurement

problem engendered in empirical studies. Section 2.6 develops the hypotheses followed

by section 2.7 the conclusion.

2.1 Agency theory: a theoretical framework

Slemrod (2004) and Crocker and Slemrod (2005) construct a foundation of the

principle-agent framework in explaining the variation in corporate tax avoidance. The

separation of ownership and control indicates that shareholders cannot directly make

the tax decision and managers may have private information about the possible

reduction strategies in income taxes. Two thoughts under agency theory link corporate

governance to tax avoidance. One traditional notion is that higher level of incentive

compensation could encourage managers to behave more aggressively in tax avoidance

planning in order to increase the wealth of shareholders (Armstrong et al. 2015). In

contrast, another situation when engaging in tax avoidance activities allows managers

for rent extraction could alter this positive relationship (Desai and Dharmapala 2006;

Desai et al. 2007). Corporate governance in turns plays an important role in resolving

the principal and agent conflicts and thus reduces agency costs (McKnight and Weir

2009). Existing literature does not make a consensus on whether there is an optimal

value-maximizing corporate governance structure (Coles et al. 2008; McKnight and

Weir 2009). The research question regarding the effect of corporate governance on tax

avoidance activities provides insight on understanding the cross-sectional variation of

tax avoidance activities and the relationship between corporate governance, firm value

and tax avoidance.

2.1.1 Traditional view

Traditional view considers tax avoidance as value-added activities which managers are

motivated to take for maximizing the value of organization (Desai et al. 2007). Since

tax avoidance decision made by managers affects firm value in a positive way, early

studies focus on the efficiency of the decision which is to assess the benefits and the

cost of being scrutinized (Phillips 2003). The implication, therefore, is that the

contractual relationship may or may not lead to more aggressive tax planning due to

market scrutiny. However, Hanlon and Heitzman (2010) pinpoint that earlier research

on companies engaging in tax avoidance activities makes no assumption of agency costs

when considering managers making corporate decisions on the aggressiveness of tax

management. Under the traditional thought, shareholders could simply address the

agency problem by motivating managers to increase after-tax performance (Kim et al.

2011), e.g. to align compensation with after-tax measurement (Phillips 2003).

The Traditional view suffered from the ignorance of agency costs. Tax avoidance

activities may allow for managerial rent extraction which could offset the reductions

effect of tax expense on maximizing shareholders’ wealth and alter the proposed

positive relationship (Desai and Dharmapala 2006; Desai et al. 2007). Therefore,

shareholders may no longer value corporate tax avoidance activities (Desai and

Dharmapala 2009). Desai and Dharmapala (2006) propose that managers may extract

rents via tax-related activities. For instance, costs of engaging in tax sheltering activities

could more or less attribute to the degree of tax avoidance which depends on the own

perspective of the manager. Tax sheltering and managerial diversion are decisions made

at the same time, and more aggressiveness in tax avoidance could imply more

managerial extraction (Desai and Dharmapala 2006).

2.1.2 Tax avoidance and managerial rent extraction

The model of Desai and Dharmapala (2006) takes account of the problem of managerial

diversion or opportunism by incorporating agency costs into the model of tax avoidance

and firm value. Corporate governance under the agency model mitigates the negative

relationship between tax avoidance and firm value. Good quality of corporate

governance aligns the interests of managers and shareholders by enforcing better

governance techniques in preventing managerial diversion. Desai et al. (2007) argue

that good practices of corporate governance limit the extent to private benefits extracted

by managers and the extent to the impact of agency costs on firm value. Desai and

Dharmapala (2006) maintain that the effect of tax avoidance is conditional to corporate

governance. They predict that firms with well corporate governance are more effective

in preventing managerial diversion and thus the corporate governance incentives could

lead to higher levels of tax avoidance but positive influences on firm value. However,

firms with poor corporate governance are more interested in reducing tax sheltering for

lowering the opportunity of rent extraction (Desai et al. 2007).

Following the framework of Desai and Dharmapala (2006), empirical research shows

evidence of the interdependence of managerial opportunism and tax avoidance. Desai

and Dharmapala (2006) find that stronger equity incentives result in lower level of tax

avoidance for weak governance companies. Chen et al. (2010) show that non-family

firms are more tax avoidance than family firms. They argue that since other

shareholders may commonly presume that family has more opportunities to mask

benefits by various activities including tax avoidance, family owners respond to forgo

the benefit to avoid discounting share value by other shareholders who concern family

may extract rents.

2.1.3 Limitation on the agency model of tax avoidance

Some research questions the underlying assumption of the agency model that tax

avoidance facilitate managers to seek their own interests. The decision of managers for

firms engaging in tax avoidance depends on factors such as the relevance of information

(Gallemore and Labro 2015), organizational forms (Robinson et al. 2010), business

strategy (Higgins et al. 2015). Evidence from other studies also challenges that

corporate governance is not necessarily the predominant reason for explaining the

negative relationship between tax avoidance and firm value. For example, managers

may be concerned about market scrutiny, or shareholders themselves may not consider

tax avoidance activities as a value maximizing activities regarding the risk of rigorous

scrutiny and severe penalty (Graham and Tucker 2006; Brooks et al. 2016; Bebchuk

and Fried 2003; Hanlon et al. 2015).

Agency theory is useful for understanding tax avoidance activities related to the

compensation, especially in the case of tax avoidance activities enabling the managerial

diversion. However, when this assumption (that tax avoidance provides a channel for

managers to seek their own interest) is not sufficiently important, agency framework

could not provide a whole explanation of the direct effect between corporate

governance and tax avoidance (Lanis and Richardson 2011). Also, when managers have

a limited discretion grant to make tax decision, corporate governance mechanism could

no longer explain the effect of tax avoidance on firm value. The decision of managers

could be significantly influenced by other variables, such as concerns of reputation cost

(Graham Tucker 2006), information quality and availability (Gallemore and Labro

2015), controllability (Robinson et al. 2010), tax knowledge (Cook et al. 2008; McGuire

et al. 2012), corporate social responsibility (Huseynov and Klamm 2012a).

2.2 Tax avoidance and firm value

Empirical evidence shows mixed results on the relationship between tax avoidance and

firm value. The inference contains a debate on whether the share price is negatively,

positively or not associated with bad news with regard to corporate tax liability. In the

world without agency costs, shareholders with different levels of risk aversion could

value tax avoidance on opposite directions and the overall effect of tax avoidance news

might therefore be offset. From the traditional point, aggressive tax planning activities

save costs and increase firm value (Kim et al. 2011). However, the traditional view is

unlikely to fully explain mixed responses. As previously discussed tax avoidance may

facilitate managerial diversion and imposes agency costs (Desai and Dharmapala 2006).

Cloyd et al. (2003) investigate the reactions of stock price to the news announcement

that firms will expatriate to tax haven countries and conclude that the market does not

believe that the benefits of fewer tax expenses outweigh or offset the costs. In terms of

news about the involvement in tax sheltering activities, Hanlon and Slemrod (2009)

adopt a method of event study and examine the response of share prices by employing

data of 108 US firms during the year 1990 to 2004. They find that share prices drop

0.5% as a reaction to tax shelters participation disclosure but the price decreases are

muted for well-governance firms. Kim et al. (2011) extend the explanatory power of

the agency model by employing a sample of US listed companies. They documented a

long run effect of more aggressive tax avoidance on firm value. All measures they used

for tax avoidance, cash ETR, large book-tax differences (BTD) and tax sheltering

incentive are found having a significant relationship with stock price drops. They also

find evidence that higher tax avoidance could predict crashes in future stock price and

external governance mechanisms diminish the risk of dropping in firm value.

In contrast, Desai and Dharmapala (2009) show evidence that there is no significant

relationship between book-tax difference (BTD)5, a proxy for measuring aggressive tax

avoidance activities (discussed more in detail in section 3.3.2) and firm value, measured

by Tobin’s q in their study. A significant effect is found in a disaggregate level consistent

with the agency framework. They show that firms with strong corporate governance

appear to have a significantly positive association between tax avoidance and firm value,

and firms with weak corporate governance shown a negative relationship. Recent UK

study by Brooks et al. (2016) uses data of FTSE All share companies and they show no

relationship between corporate tax payment and financial performance. Brooks et al.

(2016) find that despite short term falls for some small firms, there is no long-term drop

in share price relating to current ETRs, long term ETRs, BTDs, which contradicts to

the findings of Cloyd et al. (2003). They argue that tax aggressiveness of managers or

any decision on changes in tax rates represents an evaluated and rational decision

process accounting for the costs and benefits of corporate tax avoidance. They conclude

that by considering ‘responsible’ investors who keep an eye on corporate tax avoidance,

the aggressiveness of senior managers in tax avoidance will not likely to affect stock

prices. However, unlike the study of Cloyd et al. (2003) which tests the direct

relationship between stock price and corporate expatriation news in a two-year window,

the study of Brooks et al. (2016) investigates the price reaction to tax rate changes by

using long-term ETRs. The information included in ETRs and BTDs is subject to

measurement error which could be caused by the limitation of accounting-based

measures.

2.3 Corporate governance and tax avoidance

As previously discussed, tax avoidance activities may be conditional to the

effectiveness of corporate governance. Prior literature suggests that not only the overall

quality of corporate governance structure but also the individual corporate governance

mechanism relates to tax avoidance activities and have an effect on firm value. Minnick

and Noga (2010) make a comprehensive investigation of the role of corporate

governance plays in tax aggressive management and estimate whether tax planning with

better corporate governance increases the shareholder wealth in the long run. They find

the important effect of corporate governance, of which the most important driver of tax

avoidance decisions is incentive compensation, especially pay-for-performance

sensitivity. However, their study has yet to explore the world outside the US. In order

to investigate the UK practices in this research, the following sections adopt the

classification by McKnight and Weir (2009) of corporate governance characteristics:

board structure, ownership structure, incentives compensation.

5 Noted that book-tax difference could also be caused by earning management, Desai and Dharmapala (2009) used total accruals as control variable to separate the effect of tax avoidance activities.

2.3.1 Board structure and tax avoidance

A substantial literature has investigated the link between performance and board

structure, referring to the board size and the components. However, mixed results are

shown towards the optimal board structure of a corporation. Early literature suggests

that smaller and more independence board tends to have higher firm value(Jensen 1993;

Eisenberg et al. 1998; Yermack 1996). However, recent studies argue that there is no

optimal board structure. Boone et al. (2007) and Coles et al. (2008) show evidence that

board sizes and outside directors vary by firm-level characteristics. In addition, some

argue that larger board size tends to compromise more to make a consensus. Cheng

(2008) shows empirical evidence that large board is significantly related to less

volatility in firm value.

Prior studies suggest that more outside directors on board reduce the agency costs and

the new of appointment to outside directors leads to an increase in equity value

(Rosenstein and Wyatt 1990). In particular of all the research on board structure, the

study of Richardson et al. (2014) links the board effect with corporate tax avoidance

and the decision to capital structure in terms of debt policy 6 . Their study show

intervention from the broad on tax avoidance activities and find evidence that firms

with a higher fraction of outside directors increase their debt-substitution effect where

the debt-substitution effect is defined as debt being a substitute to tax aggressive

activities. The implication would be consistent with other empirical results that

companies with a higher level of board independence result in less influence of

managers (Coles et al. 2008).

Other board characteristics have also been examined in prior research but have shown

weak impact on lowering the agency costs. In contrast to the argument that gender

diversity could result in higher risk of the firm, Sila et al. (2016) find no evidence that

more women on the board affect the firm performance. McKnight and Weir (2009)

found little evidence in supportive of an important effect of the duality of CEO/Chair

on firm value. However, Bhagat and Bolton (2008) document a significantly positive

relationship between the separation of CEO/Chair and corporate operational

performance. They also conclude that an overall quality of corporate governance could

be measured by board independence or ownership structure.

2.3.2 Ownership structure and tax avoidance

Ownership structure with a composition of institutional ownership, managerial

ownership, and family ownership contributes to another part of corporate governance

mechanisms. Institutional investors are argued to be powerful shareholders with more

active engagement of voting. They are considered as having superior knowledge and

resources to monitor managers (McKnight and Weir 2009; Desai and Dharmapala

2009). Thus, a higher level of institutional ownership could better monitor managers in

order to reduce agency costs. Lim (2011) extends Desai and Dharmapala (2006) model

by examining and documenting a negative relationship between tax avoidance and cost

of debt. It is found that the negative relationship is magnified when institutional

ownership is higher. Their study adopts institutional ownership as the proxy of

6 Graham and Tucker (2006) document a debt-substitution effect. They find evidence that firms engaging in tax sheltering activities appear to have an 8% less debt ratios compared to matched pre-sheltering firms.

corporate governance7 and suggests the important effect of institutional ownership on

monitoring managerial extraction. A similar study by Kim et al. (2011) also shows that

institutional ownership as one of the external governance sources has an important

effect on mitigating the negative impact of tax avoidance on firm value. Desai and

Dharmapala (2009) also adopt institutional ownership as the proxy for governance

quality and find evidence consistent with the proposal that benefits from corporate tax

avoidance depend on the quality of corporate governance. Overall, prior evidence

suggests that higher institutional ownership leads to lower chance of rent extraction.

Under the agency model, increased managerial ownership provides more incentives for

managers to act on behalf of the interest of the shareholders. Kim and Lu (2011)

document that under weak external governance (EG) measured by industry

concentration ratio and institutional ownership concentration, CEO ownership has more

room to mitigate agency problems via motivation effect. When EG is strong, the

relationship between CEO ownership and Tobin’s q is shown being insignificant. They

also find evidence that the level of R&D investment, which is used for measuring the

risk-taking decisions of CEOs, is affected by the quality of external governance. Their

findings also provide insights on the notion of tax avoidance research under agency

model. In terms of family ownership, family firms appear to manage tax payments less

aggressively than that of non-family firms (Chen et al. 2010). However, in this case,

family owners avoid tax avoidance strategy for the reason of reputation costs and

possible penalties but not interest alignment.

2.3.3 Incentives compensation and tax avoidance

Most literature on executive incentives and CEO tax aggressive preferences focuses

mainly on compensation incentives. Empirical evidence shows that managers’ decision

on corporate tax avoidance strategies is most sensitive to managerial compensation

compared to board structure and age of the CEO (Minnick and Noga 2010). Specifically,

managerial compensations such as equity-based incentives (Rego and Wilson 2012) and

Pay-for-performance sensitivity (Minnick and Noga 2010) have been found driving

executives to behave in the way that increases shareholders’ wealth. Tournament

incentive which refers to the difference between total compensation of the CEO and

those of the near-highest paid CEO in the industry, has been found playing an important

role in affecting tax decisions. A Recent study of Kubick and Lockhart (2016) show

evidence that the external labour market has been an effective motivation for CEOs to

undertake aggressive tax strategies.

2.3.4 Other corporate governance characteristics and tax avoidance

Other corporate governance characteristics may also influence corporate tax avoidance.

In terms of characteristics of the CEO, Francis et al. (2016) show that whether the CEOs

are Democratic or Republican affect their decisions to engage in tax sheltering activities.

Other factors such as overconfidence (Huang et al. 2016) and national culture

(DeBacker et al. 2012) has shown to affect the risk adverse preference of the managers.

From the view of stakeholders, Chyz et al. (2013) examine the influence of labour

unions on corporate aggressive tax management and they document a negative

7 Noted that Desai and Dharmapala (2009) also measure institutional ownership which as the proxy of good corporate governance has been widely used in empirical literature under Desai and Dharmapala (2006) model and find consistence results.

association between tax avoidance and union power, measured by unionization rate and

bargaining power. Their findings further suggest that stakeholders are likely to have an

important effect on corporate tax aggressive strategies.

Overall, prior literature provides extensive evidence on the effect of corporate

governance and develops various measures of governance techniques. Nevertheless, it

is important to note that corporate governance varies significantly by countries. An

empirical study on UK practices by McKnight and Weir (2009) shows no significant

effect of board structure on the agency costs. Abdul Wahab and Holland (2012) also

find UK evidence contradicts to US results that corporate governance shown no

mitigating effect on agency conflicts and tax avoidance activities. They conduct a factor

analysis to determine the governance mechanism which could reflect the quality of

corporate governance. The following sections of this paper also investigate the

effectiveness of different corporate governance techniques with the purpose of testing

the relations to tax avoidance activities.

2.4 Control variables: firm characteristics

The prior literature identifies several firm characteristics for controlling the cross-

sectional variation on corporate tax avoidance activities. Earlier research has extensive

focuses on the rationale of firm size and different effective tax rates. Mixed results have

been found due to different measures of firm sizes8, sample period and the specific

model (Rego and Wilson 2012). Zimmerman (1983) show evidence that firm size is

positively related to effective tax rates (ETR)9. In terms of UK setting, Holland (1998)

documents a size effect is related to average ETR during 1968-1979 and finds a negative

relation from the late 1970s to early 1980s. In contrast, Stickney and McGee (1982) and

Gupta and Newberry (1997) find size factor has no significant relationship with ETRs

but other firm characteristics such as capital intensity, leverage, capital structure and

asset mix are shown significantly associated with ETRs.

Shiing-Wu (1991) present the result that net operating loss (NOL) has statistically

importance on the variation of ETRs. Empirical studies also document that the effect of

determinants is not widely spread across industries. Samples from oil and gas

companies were found to have highest ETRs but wholesale and retail industries resulted

in lowest ETRs (Zimmerman 1983). Klassen and Laplante (2012) identify another firm

characteristic that the high level of foreign reinvestment signals companies with

subsidiaries located in lower foreign tax rates places having more incentives as well as

opportunities to shift income. Companies with high R&D percentage are shown have

more chance to shift profits overseas (Klassen and Laplante 2012). In term of leverage,

Graham and Tucker (2006) show that compared to a control sample, tax shelter

companies have lower leverage ratios. Brooks et al. (2016) argue that capital intensive

companies could have more opportunities to avoid taxes through depreciation of assets.

8 Moore (2012) summarise that firm size can be calculated by numerous measure, e.g. net income, gross receipts, business value and number of employees. The result of this study also shows patterns in long term ETR changes. 9 The notion of earlier studies investigating variation of ETR is that under the “political risk hypothesis”, large firms are subject to greater possibility of market scrutiny and ETRs are expected to partly measure the political risks(Zimmerman 1983).

2.5 Endogeneity problem and sample bias

Endogeneity problem of corporate governance research could cause serious

measurement problems. Endogeneity occurs in a multiple regression when the

independent variable is associated with the error term. Endogeneity problem causes the

OLS estimators to be biased and inconsistent which will result in either overestimate or

underestimate the parameters. There are few cases which lead to endogeneity. First, the

regression model may exclude an important variable and the omitted variables could

affect both the independent and dependent variables. For example, there might be an

uncontrolled or unrecognized variable that affects both the CEO characteristic and

corporate tax sheltering activities (Francis et al. 2016). Second, the measurement error

of independent variable could also cause endogeneity problem. Separating tax

avoidance effect from earnings management or aggressive reporting with regard to

accounting measures of tax avoidance could be complicated. Desai and Dharmapala

(2009) state that the implication of the regression results is limited because of the

possibility of having measurement errors of tax avoidance proxies. Third, endogeneity

arises from simultaneity10 when independent variables are jointly determined with the

dependent variable. For instance, tax sheltering activities could increase company’s

market capitalization as well as motivate executives to exercise their share option(Desai

and Dharmapala 2006). Neglecting the above kinds of measurement problem could lead

to bias results or spurious relationship (Wintoki et al. 2012).

Prior empirical research makes a lot of effort in controlling for endogeneity problem by

conducting robustness test. Substantial studies include control variables and fixed effect

into the model to avoid the effect of omitted variables. Robustness test is also widely

tested in additional to the regression analysis. With regard to measurement error in

independent variables, the approach of instrumental variables (IV), which is to include

an instrument unrelated to the error term into the regression model, can solve the

inconsistency problem caused by endogeneity. However, the estimates are still bias

under IV method and the efficiency of the method is limited to the quality of the

instrument. The robustness could also be tested by including lagged variables of the

independent variables (Wintoki et al. 2012). For example, Desai and Dharmapala (2009)

check the robustness by incorporating lagged variables of the tax avoidance proxy.

Minnick and Noga (2010) include lagged differences of ETR into the model. Moreover,

a majority of studies also conduct robustness tests by using alternative measures of the

independent variables, i.e. other proxies of tax avoidance and corporate governance

techniques (Lim 2011; Abdul Wahab and Holland 2012; Desai et al. 2007).

A great number of empirical studies of corporate governance and firm value focus on

different samples from a single country to the worldwide practices. However, there is a

lack of research in investigating the links between corporate governance, tax avoidance,

and firm value apart from the view from US sample. A few studies have extended the

perspective towards evidence from Russia (Desai et al. 2007; Mironov 2013; DeBacker

et al. 2012), Korea (Lim 2011), China (Zhang et al. 2016) and the UK (Brooks et al.

2016; Abdul Wahab and Holland 2012). Little is known about the practices outside the

US. Furthermore, prior studies tend to exclude the financial industry from their sample

and the results would fail to account for the unknown characteristics of financial

institutions regarding corporate governance and tax avoidance.

10 Simultaneity is defined when X is not random but a function of Y (Wintoki et al. 2012).

For studies adopting the measurement of tax sheltering, the sample of tax sheltering

firms would be limited to those which have been publicly accused of engaging in tax

sheltering activities. The result from tax sheltering companies can be biased since it

ignores other silent firms. For instance, research using tax sheltering proxies may ignore

companies which have hidden tax avoidance activities since the sample only includes

firms being exposed of engaging in tax sheltering activities. The result of tax sheltering

model would fail to capture the firm characteristics of those silent companies(Graham

and Tucker 2006; Desai and Dharmapala 2006). Moreover, the current tax shelter

sample is based on studies of US firms, and thus the tax sheltering regression results

may be biased to non-US companies. Also, including firms which are accused of

involving in tax sheltering activities may cause endogeneity problem since the included

firms are likely to be those with the least care of social response such as reputation cost

(Graham et al. 2014).

2.6 Hypotheses development

To examine the relationship between corporate governance, tax avoidance, and firm

value, the first step would be to test the hypotheses under agency framework. The

agency framework proposes that tax avoidance activities provide greater opportunities

for managers to extract rents from the companies. Therefore, tax avoidance would

imply a decrease in firm value. A negative relationship between tax avoidance and firm

value indicate that the effect of managerial diversion outweighs the potential benefit of

tax avoidance strategies. Prior research found result consistent with the notion of

agency framework. Mironov (2013) shows that diversion activities negatively affect the

firm value. Kim et al. (2011) find a significantly positive relationship between tax

avoidance and firm idiosyncrasy risk in stock price. Thus, it could be expected that

companies with a higher level of tax avoidance have lower firm values. Accordingly,

this research test the following hypothesis (H1).

H1: Tax avoidance is negatively related to firm value.

According to Desai and Dharmapala (2006) model, the quality of corporate governance

influences the ability of managers to extract rents since well-governance companies are

more likely to have stronger control techniques that prevent managerial diversion.

According to the level of corporate governance, firms could be categorized into two

extremes. Strong corporate governance is expected to mitigate the problem of

managerial diversion, and weak governance may worsen the problem. H1 considers the

average effect of shareholder’s valuation on tax avoidance. H2 is expected to investigate

whether the quality of corporate governance makes a difference to the relationship

between firm value and tax avoidance activities.

H2: All else being equal, the negative relationship of tax avoidance and firm value is

mitigated by strong corporate governance.

There is extensive evidence that corporate governance techniques improves firm value.

In another aspect of agency framework, tax avoidance can be seen as a risky investment

available to managers similar to other investments which are influenced by corporate

governance. Without the assumption of managerial diversion, several studies examine

how corporate governance would improve firm value by testing the direct relationship

between corporate governance and tax avoidance. Armstrong et al. (2015) argue that

given the unsolved Principle-agent problem, managers may choose a level of tax

avoidance which shareholders may disagree. The third hypothesis (H3) examines the

direct relationship between corporate governance and tax avoidance by incorporating

various corporate governance mechanisms into the model.

H3: Increased quality of corporate governance techniques leads to higher tax avoidance,

in other words, lower tax expenses.

The test of H3 does not necessarily assume that tax avoidance activities create

opportunities for rent extraction. But it assumes that various corporate governance

techniques mitigate the agency problem by controlling tax avoidance activities

(Armstrong et al. 2015). Within the agency model, strong governance better aligns the

interest of managers with corporate value-maximization. H3 further investigates the

specific corporate governance techniques (board size, board independence, the duality

of the CEO, ownership structure, and stock compensation) that tax avoidance activities

are sensitive to. Larger boards may have more difficulties in convincing managers to

allocate resources to tax avoidance activities. Independence board can be more flexible

in diverting resources to tax avoidance which implies that more independence board

has greater incentives to pursue a higher level of tax avoidance. In terms of

compensation, since the purpose of managerial incentives is to motivate managers

acting on behalf of shareholders, higher stock compensation is expected to result in

lower tax expenses, in other words, higher tax avoidance is likely to be associated with

higher stock incentives. Alternatively, H3 can be stated as above. Noted that the tests

of H1, H2 and H3 are all single-sided test.

2.7 Summary of literature review

The agency framework lays a foundation for empirical research to investigate the

relationship between corporate governance tax avoidance and firm value. The model of

Desai and Dharmapala (2006) extends the theoretical ground by assuming managerial

opportunism with regards to tax avoidance activities. Tax-related literature also

contributes to the knowledge of how corporate governance affect firm value. Research

under agency framework advances the knowledge of the effect of corporate governance

on the relationship between tax avoidance behaviours and firm value. Second, research

on this areas jointly examines the role of corporate governance as well as tax avoidance

activities on firm value. Third, the research also sheds light on the other consequences

of the interaction between corporate governance and tax avoidance, such as debt policy,

the cost of debt, bondholders. Further research of these areas will possibly push the

boundaries of existing body of knowledge to corporate governance regarding many

other disciplines.

3. Methodology

3.1 Research design

𝐹𝑉𝑖𝑡 = 𝛽0 + 𝛽1𝑇𝐴𝑖𝑡 + ∑ 𝛽𝑛𝐶𝑜𝑛𝑟𝑜𝑙𝑖𝑡

6

𝑛=2

+ 𝜃𝑡 + 𝛿𝑖 + 𝜖𝑖𝑡 (1)

Following the regression model from previous studies by Mironov (2013), Desai and

Dharmapala (2009) and Kim and Lu (2011), equation (1) is the regression model for

testing H1. 𝐹𝑉𝑖𝑡 is the firm value which has been measured by Tobin’s q (most

common proxy) and market capitalization (Brooks et al. 2016; Desai and Dharmapala

2009). 𝛽0 is the constant. The coefficient of tax avoidance is 𝛽1 which implies the

sensitivity of the firm value to changes in tax avoidance levels across firms. According

to H1, 𝛽1 is expected to be negative for BTD based measures, and be positive for ETR

measure. 𝑇𝐴𝑖𝑡 is the measure of corporate tax avoidance which is measured by current

ETR, BTD and permanent BTD. 𝜃𝑡 controls for firm-fixed effect and 𝛿𝑖 controls for

year-fixed effect. ∑ 𝛽𝑛𝐶𝑜𝑛𝑟𝑜𝑙𝑖𝑡6𝑛=2 are control variables for various firm

characteristics including size measured by sales, foreign income, R&D expense,

leverage and capital intensity (Zimmerman 1983; Gupta and Newberry 1997; Shiing-

Wu 1991; Klassen and Laplante 2012).

𝐹𝑉𝑖𝑡 = 𝛽0 + 𝛽1𝑇𝐴𝑖𝑡 + 𝛽2𝐶𝐺𝑖𝑡 + 𝛽3𝑇𝐴𝑖𝑡 × 𝐶𝐺𝑖𝑡 + ∑ 𝛽𝑛𝐶𝑜𝑛𝑟𝑜𝑙𝑖𝑡

8

𝑛=4

+ 𝜃𝑡 + 𝛿𝑖

+ 𝜖𝑖𝑡 (2)

Equation (2) is the regression model for testing H2 where 𝐶𝐺𝑖𝑡 is the proxy for

corporate governance which is measured by corporate governance score. According to

the H2, 𝛽3 is expected to be positive when using BTD-based measures and to be

negative when using ETR-based measures, which implies that when corporate

governance has higher quality, the effect of tax avoidance on firm value is greater across

time and firms(Desai and Dharmapala 2009). Equation (3) is the regression model for

testing H3 following Minnick and Noga (2010) and Huseynov and Klamm (2012),

where 𝛽1−6 measure the effect of each corporate governance techniques on corporate

tax avoidance activities. ∑ 𝐶𝐺𝑖𝑡 represent three types of corporate governance

techniques, board structure, ownership structure and managerial incentives. According

to available corporate governance data in Datastream, ∑ 𝐶𝐺𝑖𝑡 includes corporate

governance mechanisms proxies as board size, board independence, CEO/Chairman

duality, ownership structure, CEO stock compensation and total senior executives

compensation.

𝑇𝐴𝑖𝑡 = 𝛽0 + ∑ 𝛽𝑛𝐶𝐺𝑖𝑡

6

𝑛=1

+ ∑ 𝛽𝑚𝐶𝑜𝑛𝑟𝑜𝑙𝑖𝑡

11

𝑚=7

+ 𝜃𝑡 + 𝛿𝑖 + 𝜖𝑖𝑡 (3)

It is noticed that substantial literature focuses on the most aggressive form of tax

avoidance. Several studies using GAAP ETR and Current ETR find no significant

relationship between firm value and tax avoidance (Brooks et al. 2016). Equation (2)

captures the average effect of corporate governance on the mitigation of agency

conflicts using Ordinary least square (OLS) method. Prior research has adopted two

methods in examining the effect of corporate governance without narrowing the view

on the central location of the sample distribution. Armstrong et al. (2015) use quantile

regressions to provide a view of the distribution and to allow for analysis of special

quantiles (Valta 2012). The other method is to classify the whole sample into

subsamples of good corporate governance and bad corporate governance firms, and

then re-run the regression for H1 and H2 on each sub-samples for comparing the

coefficients, 𝛽1and 𝛽3, of each subsample as well as the whole sample (Kim and Lu

2011; Desai and Dharmapala 2009). It is also noticeable that the regression model can

incorporate long term measures of tax avoidance, such as long-run ETRs (Dyreng et al.

2008), matching with other variables along the same period of time (Minnick and Noga

2010). The discussion of long term tax avoidance activities is not included in this paper,

however, it is a further aspect of investigation.

3.2 Measuring corporate governance

This paper employs as many of relevant corporate governance mechanisms as these are

available to Thomson Reuters ASSET4 ESG database. Thomson Reuters Datastream

ASSET4 ESG has provided timely and comprehensive data regarding environmental,

social and corporate governance (ESG) issues for more than 5000 global companies

including UK company level data since 2002. Data from ASSET4 ESG have been

widely used and tested in the recent UK and US studies (Boubakri et al. 2016; Lys et

al. 2015; Halbritter and Dorfleitner 2015; Stellner et al. 2015; Ferrell et al. 2016).

ASSET4 ESG is therefore considered as a reliable source of the database to obtain

corporate governance data.

Prior research has employed different proxies, such as institutional ownership, board

independence, and corporate governance score to measure the quality of corporate

governance. According to the UK study by Abdul Wahab and Holland (2012), board

independence referring to the proportion of outside directors on the board, and

institutional ownership defined as the proportion of shares held by institutions, are

found as the corporate governance mechanism that can capture the board corporate

governance level. Due to data availability, institutional ownership cannot be obtained

via Thomson ASSET4 ESG. This paper therefore primarily uses board independence

as the measure of corporate governance. Board independence (BI) (#CGBSO07S) is the

percentage of non-executive directors on the board. The underlying notion of this

measure is that independent directors have greater motivation and capacity to monitor

the performance of managers.

In terms of corporate governance score, Wilson (2009) documents that tax shelter

companies with better corporate governance, measured by corporate governance scores,

show higher abnormal returns. He uses corporate governance score of Gompers et al.

(2003) index ranging from 0 to 24 to measure the quality of corporate governance and

breaks the sample by the median score to distinguish good and bad corporate

governance. Hanlon and Slemrod (2009) also employ corporate governance score from

Gompers et al. (2003) to an event study of share price reaction to tax sheltering news.

Doidge and Dyck (2015) use another corporate governance score which has a range

from 0 to 100 to study the role of tax incentives on corporate decision making.

Corporate governance (CG) (#CGVSCORE) used in this paper is scores which measure

the system and process of a firm in ensuring board members and managers behave in

the best interest of shareholders. It has a range from 0 to 100 and is provided by

ASSET4 ESG. However, there is a lack of evidence relates to the reliability of the

corporate governance score provided by ASSET4 ESG, and thus this paper considers

corporate governance score as an additional measure to test Equation (2) apart from the

main results by board independence.

With regard to specific corporate governance mechanisms, this paper employs board

size, CEO/Chairman duality, ownership structure indicator, stock compensation for

executives and total senior executives compensation. Board size (BS) (#CGBS) is

measured by the total number of board members at the end of each financial year.

CEO/Chairman duality (CCD) (#CGBSO09S) is a dummy variable that equals 1 if the

chairman is also the CEO and equals to 0 when there is no duality. Ownership structure

(OSTR) (#CGSRO05S) is represented by scores which evaluate whether a powerful

shareholder has the majority of the votes. CEO stock compensation (CEOC)

(#CGCPDP041) is a dummy variable which equals to 1 when CEO’s compensation is

linked to total shareholder return and equals to 0 when it is not the case. Total senior

executives compensation (TOMP) (#CGCPDP054) is defined as the value of total

compensation paid to all senior executives.

3.3 Measuring tax avoidance: the extreme effect versus average effect

There has been a wide range of measures capturing different levels of corporate tax

avoidance. Since each measure of tax avoidance has its own inference and limitations,

extant research tends to include few proxies together into the analysis to obtain wider

inference. As tax avoidance generally refers to a continuum of tax reduction behaviours,

measures capturing the extent to tax avoidance have different inferences and limitations.

Hanlon and Heitzman (2010) state that the choice of tax avoidance proxy depends on

the specific research question. In order to choose tax avoidance measures for this

research, the following part summarizes and reviews measures which are frequently

used in prior literature (Table 1).

3.3.1 ETR-based measures

Effective tax rates (ETRs) have been most widely used for measuring tax avoidance in

prior research. By changing the definition of the numerator (Table 1), ETRs proxies

could reflect various tax avoidance behaviours. Earlier studies commonly measure the

average ETRs (also as GAAP ETRs or book ETRs) which incorporate both timing

effect of deferred strategies and aggressive tax planning activities (Hanlon and

Heitzman 2010; Abdul Wahab and Holland 2012). It has good properties in reflecting

the overall effect of tax avoidance activities which is directly related to accounting

income while it fails to distinguish the forms of avoidance (Dyreng et al. 2008). Current

ETR and cash ETR (defined in table1) appear to overcome the problem of detecting the

deferral tax charges. Prior studies document that cash ETRs show more volatility than

GAAP ETRs (Dyreng et al. 2010) and low ETRs show persistence over a long period

of time (Dyreng et al. 2008)11. GAAP ETR, current ETR, and Cash ETR are all short-

term proxies which could be affected by accounting accruals. Dyreng et al. (2008)

develop the concept and measure of long run ETR for capturing a longer horizon of tax

management and the long-term effect of determinants. Long run ETRs avoid the impact

of one single event (Minnick and Noga 2010; Dyreng et al. 2008) and also overcome

the problem of mismatching cash taxes with earnings(Hanlon and Heitzman 2010).

ETR volatility is the standard deviation of ETRs.

Discretionary permanent book-tax differences (DTAX) is the unexplained part between

ETR and statutory tax rate differential, see Frank et al. (2009). DTAX measures the

discretionary portion of tax avoidance activities and is associated with actual cases of

tax sheltering (Frank et al. 2009). However, Hanlon and Heitzman (2010) argue that

DTAX is likely to be problematic since the model requires non-tax driven determinants

but it is hard to decide one since the tax has potential effect on many corporate decisions.

The failure in using valid proxies would thus lead to additional error. Both measures

capture the variation of ETRs. ETR volatility and DTAX show the extent to tax

avoidance activity, although the variability could also be attributed to other changes.

11 It is possible that cash/current ETRs tend to overstate the tax burden due to compliance between accounting standards and tax law. For instance, more accelerated depreciation method distort the result of cash/current ETRs but not that of GAAP ETRs (Huseynov and Klamm 2012a; Hanlon and Heitzman 2010; Dyreng et al. 2010).

TP = Statutaryrate𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 ×(Perminant difference + timing difference) +STRDIFF = Pretax profit ×

(Statutaryrate𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 −𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡)

12 Some studies use book income less special items as the denominator which would not cause big difference. 13 Dyreng et al. (2008) develops the long run ETR measure and the measurement period could normally take up to from 3 years to as long as 10 years. Similarly, Minnick and Noga (2010) measure long run

GAAP ETR which the numerator is calculated by sum of total tax expense over the given period. 14 See Gallemore and Labro (2015). 15 Frank et al. (2009) develop the measure of DTAX which incorporate the effect of tax avoidance on accounting earnings. 16 The method of tax sheltering model initially proposed by Wilson (2009)and then developed by Lisowsky (2010) to estimate the probability(𝑝𝑡𝑎𝑥 𝑠ℎ𝑒𝑙𝑡𝑒𝑟) of tax sheltering. 17 See Abdul Wahab and Holland (2012). They define STRDIF as the ETR reconciliation which is calculated by STRDIF = (Statutary rate𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 − Statutary Rate𝑜𝑣𝑒𝑟𝑠𝑒𝑒) × TP𝑜𝑣𝑒𝑟𝑠𝑒𝑎𝑠

Table 1 Measures of corporate tax avoidance

Measure Definition Calculation Duration

measured

Indicate

deferral

strategies?

Indicate

conforming

activities?

Related to

accounting

earnings?

Reflect

aggressiven

ess?

ETR-based measures GAAP ETR or

Book ETR12

Total tax payment per book income before tax One year No No Yes General

Current ETR Current tax expense per book income before tax One year Yes No Partly General

Cash ETR Overall cash taxes outflows per book income

before tax One year Yes No No General

Long-run cash

ETR13

Total cash paid for tax over total pre-tax

income Multiple years Yes No No General

ETR volatility14 The standard deviation of cash ETR over a

given period Multiple years Yes No Yes General

DTAX15 Discretionary permanent book-tax differences,

i.e. the unexplained part between ETR and

statutory tax rate differential

Residual from the regression ETR Differential× Pretax accounting income= α + βControls + ε

One year No No Yes Extreme

BTD-based measures

Total BTD Total book and taxable income differences One year Yes No Yes General

Temporary

BTD

Timing differences including loss relief One year Yes No Yes Moderate

Permanent BTD Permanent differences between accounting

income and taxable income. One year No No No Moderate or

extreme

Tax shelter

Tax shelter

indicator16

Dummy variable set equals to 1 if firm is

engaged in tax sheltering

𝑝𝑡𝑎𝑥 𝑠ℎ𝑒𝑙𝑡𝑒𝑟

1 − 𝑝𝑡𝑎𝑥 𝑠ℎ𝑒𝑙𝑡𝑒𝑟= α + βX + ε One particular

year

Might be Partly Depends Extreme

Tax planning

incentive17

The extent to tax planning considering after-tax

effect

One year Might be Partly Depends General

UTB Unrecognized tax benefits attribute to uncertain

tax position Disclosure of financial reporting One year If known, yes Partly Yes Extreme

𝑇𝑜𝑡𝑎𝑙 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝑃𝑟𝑒 − 𝑡𝑎𝑥 𝑎𝑐𝑐𝑜𝑢𝑡𝑛𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝑃𝑟𝑒 − 𝑡𝑎𝑥 𝑎𝑐𝑐𝑜𝑢𝑡𝑛𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒

𝐶𝑎𝑠ℎ 𝑡𝑎𝑥𝑒𝑠 𝑝𝑎𝑖𝑑

𝑃𝑟𝑒 − 𝑡𝑎𝑥 𝑎𝑐𝑐𝑜𝑢𝑡𝑛𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒

√1

𝑡∑(𝑐𝑎𝑠ℎ 𝐸𝑇𝑅𝑡 − 𝐸𝑇𝑅𝑡

)

∑ 𝐶𝑎𝑠ℎ 𝑡𝑎𝑥𝑒𝑠 𝑝𝑎𝑖𝑑𝑡

∑ 𝑃𝑟𝑒 − 𝑡𝑎𝑥 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒𝑡

Overall, since firms have incentives to reduce taxes, prior research suggests that lower

ratio of ETRs indicates a higher level of tax avoidance. Higher ETR volatility or higher

DTAX indicates increased tax avoidance (Frank et al. 2009; Rego and Wilson 2012).

Effective tax rates (ETRs)-based proxies reflect some degree of tax avoidance. However,

since ETRs are accounting-based measures, they would include the effect of other

causes such as aggressive financial reporting. The measures would be noisy as the

inference could not be specified. But ETR-based measures have a merit that they enable

for running large sample since ETR data are highly visible.

3.3.2 BTD measure and contrast

Book-tax differences (BTDs) measure the overall effect between accounting profit and

taxable income (Abdul Wahab and Holland 2012a; Hanlon 2003). BTD is composed of

permanent differences and temporary differences. Results from prior studies show that

BTDs carry additional meaning of earning quality, i.e. earning growing or earning

persistence which may link to earning management (Graham et al. 2012). Blaylock et

al. (2012) show evidence of large BTDs relating to a lower level of earning and accruals

persistence. Abdul Wahab and Holland (2015) provide evidence that the persistence of

accounting earnings varied by the nature of BTDs and the difference of persistence is

sensitive to industrial types. Wilson (2009) documents a more direct relationship that

tax sheltering results in BTDs. Their result implies that either temporary or permanent

BTDs could reflect part of corporate tax avoidance levels. Lisowsky (2010) finds

consistent results that total BTDs are associated with the engagement of tax sheltering18.

Overall, since BTDs could be decomposed into less aggregate levels, the BTDs measure

could be used for empirical research with different focuses. Unlike ETR measures,

BTDs could not be directly made a comparison to any benchmark before matching with

similar firms (Abdul Wahab and Holland 2012a). Both BTDs and ETRs capture only

the non-conforming tax avoidance, since they are all deviations of accounting earnings

(Hanlon and Heitzman 2010).

Conformity tax avoidance transactions reduce tax liability together with reducing

accounting earnings. Conforming tax avoidance activities cannot be measured by

accounting income-based measures as they result in non-discretionary differences, e.g.

transactional changes that certain kinds of tax avoidance activities could cause. The

differences (which have long been neglected) that conformity activities could have

made on the firm level variation of tax avoidance are argued to be one of the causes of

the unexplained term in current tax avoidance model.

3.3.3 Tax shelter and other measures

Tax shelter proxy has a pure focus on the economic content of tax avoidance activities

regardless of the aggressiveness in financial reporting (Lisowsky 2010). Wilson (2009)

proposed a prediction model to measure the estimated probability of a firm engaging in

tax sheltering. Tax shelter proxies are expected to capture a more extreme extent of tax

avoidance activities (Wilson 2009; Chyz 2013). However, it may be plausible to expect

a stronger relationship using a proxy of more severe tax avoidance. The sample of

extant empirical research on tax sheltering is limited to US firms which were 18 Additionally, no significant relationship has been found between discretionary permanent BTDs (or long run cash ETR) and tax sheltering (Lisowsky 2010).

historically detected for engaging in tax sheltering activities (Graham et al. 2014;

Hanlon and Heitzman 2010). Empirical results would be difficult to generalize to

practices in other countries and to other firms not yet been found of engaging in tax

sheltering activities. Thus, tax shelter reflects aggressive tax avoidance activities but

the current method of measuring tax shelters may not be valid for non-US research as

well as research focusing on a general level of tax avoidance behaviours.

Other proxies (Table 1) like tax planning incentives measure tax avoidance at a

disaggregate level. By decomposing tax planning activities into temporary timing

differences, statutory rate differences and permanent differences, tax planning

incentives emphasize dynamic forms of tax avoidance (Abdul Wahab and Holland

2012a). Unrecognized tax benefits(UTB) is used as a measure of tax avoidance in

empirical tax avoidance research initially by Rego and Wilson (2012) in their UTB

prediction model. Prior research (Waegenaere et al. 2015) suggests that UTB is

sensitive to corporate tax avoidance level and greater UTB could be expected to

associate with more involvement of tax sheltering activities (Lisowsky et al. 2013).

However, an aggregate UTB alone could be less reflective on the tax avoidance since

the factors influencing UTB do not necessarily indicate that the weak tax position is

caused by tax planning behaviours.

3.3.4 Tax avoidance measure selection

One extreme of tax management could be completely risk-free activities, for example,

environmental taxes is designed to impose costs to those unfavourable behaviours, and

the tax authority encourages companies to avoid this kind of taxes. Research regarding

the rationale of corporate governance and tax avoidance activities, commonly adopts a

more aggressive end of the continuum (more risks induced)19 of tax management

activities. For example, to use measures of tax avoidance which would not be affected

by accounting profits, such as discretionary book-tax differences(DTAX) (Francis et al.

2016; Kubick and Lockhart 2016; Kim et al. 2011; Hasan et al. 2014) and tax

sheltering20dummy (Graham and Tucker 2006; Desai and Dharmapala 2006; Chyz et

al. 2013). However, prior research using tax sheltering measures adopts a sample of US

companies engaging in tax sheltering cases and the regression results for calculating

tax sheltering proxy is in turns not sensible to apply to UK companies. In terms of

DTAX, it is developed from the US sample which has accounts different from the UK

firms. For example, DTAX is the residual of the regression.

𝑃𝐸𝑅𝑀𝐷𝐼𝐹𝐹 = 𝛽0 + 𝛽1𝐼𝑁𝑇𝐴𝑁𝐺 + 𝛽2𝑈𝑁𝐶𝑂𝑁 + 𝛽3𝑀𝐼 + 𝛽4𝐶𝑆𝑇𝐸 + 𝛽1∆𝑁𝑂𝐿+ 𝛽1𝐿𝐴𝐺𝑃𝐸𝑅𝑀 + 휀

where data of current state income tax expense (CSTE) and the account of net operating

loss (NOL) are not applicable to UK firms. Therefore, measuring tax avoidance using

DTAX for UK sample would not be plausible either. Following prior theoretical models,

this research focuses on the condition effect of corporate governance and thus uses

current ETR, BTD and permanent BTD to measure corporate tax avoidance.

19 Tax avoidance which could always has an uncertain legal position since most companies would not take risk in obeying the law but from the view of tax authority, HMRC (2015), might behave in obeying the spirit of the law. 20 Graham and Tucker (2006) identify 44 tax shelter cases which contains tax shields such as lease-in/lease out (LILO), transfer pricing (with higher usage in their sample), tax havens, and corporate-owned life insurance.

Current ETR (Chen et al. 2010; Dyreng et al. 2008; Minnick and Noga 2010) is

measured by C_ETR:

𝐶_𝐸𝑇𝑅 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝑃𝑟𝑒𝑡𝑎𝑥 𝐼𝑛𝑐𝑜𝑚𝑒

The current tax expense (TAXS) (#01451) is the cash tax paid to tax authority displayed

in the income statement. The pre-tax income is profit before tax (PRT) (#01401) in UK

practices. Note that pre-tax income is the profit not including extraordinary items.

Following UK tax research of Brooks et al. (2016), the book-tax difference(BTD) is

defined as:

𝐵𝑇𝐷 =𝐵𝑜𝑜𝑘 𝑖𝑛𝑐𝑜𝑚𝑒 −

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑆𝑡𝑎𝑡𝑢𝑡𝑜𝑟𝑦 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒

𝐿𝑎𝑔𝑔𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

Book income is represented by the pre-tax income (#01401). The statutory tax rate is

the main rate of UK corporate tax rate at financial year t. Total assets are the lagged

assets (TOA) (#02999) in the previous year of a company.

The permanent book-tax difference (PBTD) uses the total tax which arguably captures

a more aggressive form of corporate tax avoidance(Brooks et al. 2016). Deferred tax

(DEF) (#WC03263) is the timing effect of reporting revenue for tax and financial

reporting purposes. Permanent BTD is defined following Brooks et al. (2016) as:

𝑃𝐵𝑇𝐷 =𝐵𝑜𝑜𝑘 𝑖𝑛𝑐𝑜𝑚𝑒 −

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 + 𝐷𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑡𝑎𝑥𝑆𝑡𝑎𝑡𝑢𝑡𝑜𝑟𝑦 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒

𝐿𝑎𝑔𝑔𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

3.4 Measuring firm value

Since the paper focuses on the shareholder’s valuation on corporate tax avoidance and

corporate governance, market capitalization is used as a proxy for firm value. Following

Brooks et al. (2016), market value (MV) is defined as:

𝑀𝑉 =𝐶𝑙𝑜𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 × 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

1,000,000

Based on the corporate finance literature on the determinants of firm value, this research

follows the standard by using Tobin’s q to measure firm value. Noted that there is no

strong theoretical background which suggests that Tobin’s q is important in representing

firm value with regard to tax avoidance research. This paper includes Tobin’s q since

there is empirical evidence that tax avoidance has an impact conditional to corporate

governance on the firm value measured by q (Desai and Dharmapala 2009). The

definition of q following Desai and Dharmapala (2009) and Chyz (2013) is the market

value of assets divided by book value of assets.

𝑞

=𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐶𝑙𝑜𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 × 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠

4. Sample and data collection

The sample of listed firms in London Stock Exchange is defined as all constituents of

the FTSE 350 Index over the period of 2008 to 2015. The FTSE 350 is a capitalization-

weighted index of the largest 350 companies listing on the main market of the London

Stock Exchange. It compromises 350 companies which are the combination of the

largest 100 firms constituting the FTSE 100 Index and the next largest 250 firms

constituting the FTSE 250 Index. Table 2 contains the definition of variables in the

following discussion and specifies the database from which the whole sample is

obtained. Tax and corporate financial data are collected from Thomson Datastream with

some missing data supplemented from Compustat Global via Wharton Research Data

Services (WRDS). Corporate governance data is obtained from Thomson ASSET4 ESG

via Datastream and omitted data is supplemented from corporate annual reports.

Table 2 Definition of variables

Variables Definition Dataset

Firm value

q Tobin’s q Computed

MV Market capitalization(#WC08001/1,000) Thomson Datastream

Firm characteristics

SALES Sales=revenue(#WC01001)/1000 Thomson Datastream

FORIN Foreign income=foreign sales (#WC08731)/ total net

sales(#WC01001) Thomson Datastream

RD R&D=R&D expenditure (#WC01201)/ lagged total assets

(#WC02999)

Thomson Datastream/ Compustat Global

LEV Leverage(#WC08226) measured by D/E ratio=long term

debt (#WC03251)/ common equity (#WC02999)

Thomson Datastream/

Compustat Global

CAPIN Capital intensity=Gross machinery and equipment

(#18377)/ total assets (#WC02999) Thomson Datastream

Tax variables

C_ETR Current ETR Thomson Datastream

BTD Book-tax difference Computed

PBTD Permanent Book-tax difference Computed

Corporate governance

CG Corporate governance score Thomson ASSET4 ESG

BS Board size Thomson ASSET4 ESG

BI Board independence Thomson ASSET4 ESG/

Annual report

CCD CEO/Chairman duality Thomson ASSET4 ESG/

Annual report

OSTR Ownership structure Thomson ASSET4 ESG

CEOC CEO stock compensation Thomson ASSET4 ESG/

Annual report

TCOMP Total senior executives compensation Thomson ASSET4 ESG

The sample initially consists of 350 companies on FTSE 350 and is left with 256 after

excluding (i) companies from the financial industry. Companies in the final sample also

need to meet the criteria of (ii) having complete data from three sources, i.e. Thomson

Datastream, Compustat Global and companies’ annual reports, (iii) having non-

negative pre-tax income as well as non-negative current tax expense. The final sample

also (vi) exclude abnormal extreme values. After applying the criteria, it leads to a

sample with 304 observations for 38 companies at firm-year levels over the period of

2008 to 2015. Due to missing data of several corporate governance proxies, the sample

for testing Equation (3) is scaled down to 38 companies with 152 observations over the

period of 2010 to 2013.

Table 3 presents the descriptive statistics for all the sample of 304 firm-year

observations used in equation (a), (2) and (3), including the number of observations,

mean, standard deviation and five percentiles value of the variables. According to Table

3, both of the firm value proxies are skewed to the left with mean being larger than the

median.

Table 3 Descriptive statistics

Variable N Mean Std dev Percentiles

Min 25 50 75 Max

PRT(£m) 304 806.78 2075.56 14.80 90.55 161.82 667.75 19700.00

TAXS(£m) 304 225.01 656.77 4.10 20.10 39.03 157.95 5120.01

DEF(£m) 304 272.90 736.01 -812.20 -2.75 20.60 146.85 4297.00

TOA(£m) 304 7678.73 14100.00 100.92 860.20 2335.31 7526.13 86700.00

MV(£m) 304 8993.02 17877.29 225.27 923.42 2203.46 7114.87 130509.50

q 304 1.95 0.77 0.85 1.39 1.75 2.30 5.68

C_ETR 304 0.26 0.13 0.02 0.21 0.25 0.29 1.31

BTD 304 0.00 0.03 -0.14 -0.01 0.00 0.02 0.15

PBTD 304 -0.07 0.18 -0.73 -0.17 -0.05 0.02 0.77

SALES(£m) 304 5401.59 6974.13 103.82 1239.30 2507.25 9158.55 45502.38

FORIN 304 0.44 0.42 0.00 0.00 0.43 0.76 1.64

RD 304 0.01 0.01 0.00 0.00 0.00 0.00 0.07

LEV 304 0.85 1.82 -13.95 0.17 0.45 0.94 16.82

CAPIN 304 0.20 0.22 0.00 0.06 0.14 0.24 0.92

CG 304 80.46 13.16 32.74 75.29 83.99 89.98 96.93

BS 304 9.36 2.31 5.00 8.00 9.00 10.00 18.00

BI 304 51.67 20.62 0.00 46.72 55.56 62.66 93.31

CCD 304 0.02 0.14 0.00 0.00 0.00 0.00 1.00

OSTR 304 64.04 14.80 0.84 66.95 67.73 67.90 67.92

CEOC 304 0.76 0.43 0.00 1.00 1.00 1.00 1.00

TCOMP(£m) 304 10.83 22.41 0.00 2.67 5.18 10.65 330.50

𝐂_𝐄𝐓𝐑𝒕−𝟏 152 0.28 0.15 0.09 0.22 0.26 0.30 1.31

𝐂_𝐄𝐓𝐑𝒕−𝟐 152 0.29 0.14 0.09 0.23 0.28 0.31 1.31

𝐁𝐓𝐃𝒕−𝟏 152 0.00 0.03 -0.13 -0.01 0.00 0.02 0.06

𝐁𝐓𝐃𝒕−𝟐 152 0.00 0.03 -0.13 -0.01 0.00 0.02 0.15

𝐏𝐁𝐓𝐃𝒕−𝟏 152 -0.06 0.18 -0.65 -0.17 -0.05 0.02 0.77

𝐏𝐁𝐓𝐃𝒕−𝟐 152 -0.07 0.19 -0.73 -0.18 -0.05 0.02 0.77

Year 2008 2009 2010 2011 2012 2013 2014 2015

Statutory tax rate 0.29 0.28 0.28 0.27 0.25 0.23 0.22 0.20

The mean of cash effective tax rate (C_ETR) is 26% which is much higher than the

median (25%). The book-tax difference (BTD) has the same mean and median of a zero

BTD which implies that on average 38 firms pay all the taxes due. The value of each of

the tax avoidance measures (C_ETR, BTD and PBTD) has a wide range, which

indicates various practices of corporate tax avoidance behaviours. In terms of the

percentiles, current ETRs start to be higher than statutory tax rate at the 25% point. At

the highest 95%, BTD contains the amount as much as 15% of the firm’s total assets.

As shown in Table 3, the corporate governance score (CG) is skewed to the right with

a range from 32.74 to 96.93. The average board size is night directors of which slightly

above half (55.56%) are independence directors. The majority of firms in the sample

have two different individuals being the CEO and the chair of the board. According to

the scores of OSTR, there are powerful shareholders who hold a majority of votes for

the company. Most executive directors have compensation related to stock performance

and the total senior compensation paid at an average of £10,826,292.

5. Empirical results

Hypothesis H1 predicts a negative relationship between tax avoidance and firm value

since it assumes managerial diversion which makes a discount on shareholders’

valuation. The result of H1 is reported in Table 4 including the control variables. Since

the panel data could result in repeating features at firm levels, i.e. cross-sectional

dependence, the results based on standard errors are reported using robust (White)

standard errors clustered at the firm level to control for heteroscedasticity. To decide on

whether to include fixed or random effects, Hausman test is used to test the null

hypothesis that there is no unique error correlated with the estimates. If the result of

Hausman test shows a rejection of the null hypothesis, it suggests that the fixed effect

model should be used21. A further joint test is used for testing whether a year fixed effect

should be included. If the result of the test rejects the null hypothesis that dummies for

all years are jointly equal to zero, then time-fixed effects are needed22.

The model I, II and III are tested by the same hypothesis with different measures of tax

avoidance, using current ETR, BTD and permanent BTD. PBTD arguably captures a

more severe form of tax avoidance behaviours. C_ETR and BTD tend to cover a wider

range of tax avoidance activities and since C_ETR and BTD are nearly centrally

distributed (Table 3) the overall effect of tax avoidance may be offset. When the

dependent variable measuring the firm value is market capitalization, all three models

show a positive but not statistically significant effect of tax avoidance on firm value.

By conducting one-sided z tests for testing H1, the results of all models using MV (p-

value = 0.886, 0.931 and 0.513 respectively) reject the null hypothesis that there is a

negative relationship between tax avoidance and firm value.

Column 5, 6 and 7 in Table 4 present the coefficient estimates where Tobin’s q is used

21 The results of Hausman test for Equation(1) of model I, II and III are 0.3469, 0.2726 and 0.1963 respectively, which are all below 0.05 suggesting that there is no need to use fixed effect model. Consistent with the results of Hausman test, the results of Breusch-Pagan Lagrange multiplier (LM) tests also reject the null hypothesis that there is no significant difference across units and conclude that random effects is appropriate. 22 The results of the test show that Prob > chi2 = 0.0126, 0.0124 and 0.0022 and thus we reject the null and conclude that time fixed effects are needed.

as the dependent variable. Models using market capitalization as the dependent variable

present higher R-squares of 73%. However, models using q show a drop by 61% in R-

square. By comparing R-squared, regression models using q lose their explanatory

power. Similar to the prior results of model I and II, the overall effect of tax avoidance

proxies shows a positive but insignificant relationship with firm value. These results

are consistent with those of Desai and Dharmapala (2009) (tax avoidance measured by

BTD in their case). In contrast to H1, the coefficient of PBTD is significant at 10%

level, indicating that every 1% increase in permanent BTD (PBTD) leads to an increase

of 1.42 in Tobin’s q.

The coefficients of the control variables are, to a great extent, consistent with those

results of prior research. SALES is significantly positively related to firm value, which

is consistent with the findings of Lim (2011). Consistent with Kim et al. (2011) and

Abdul Wahab and Holland (2012), the coefficients of LEV (D/E ratio) are negative,

suggesting a higher debt finance could lower firm value. In the model I and II, the

coefficients of RD appear to have a significant impact on q suggesting that higher R&D

expense is related to higher firm value.

In sum, the tests of hypotheses reject H1 and the overall effect of tax avoidance

measures on firm value is positive and insignificant. This paper cannot find a negative

relationship between tax avoidance and firm value for the sample. The findings of

Equation (1) are consistent with recent UK evidence by Brooks et al. (2016) who

Table 4 Panel regression for the effect of tax avoidance on market capitalization and Tobin's q using robust

standard errors clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)

Dependent variable MV Tobin's q

Models I II III I II III

C_ETR -4088.07 -0.35

(-1.2) (-1.29)

BTD 30358.21 1.40

(1.48) (1.27)

PBTD -214.78 1.42***

(-0.03) (2.78)

SALES 1.910*** 1.93*** 1.92*** 0.00 0.00 0.00

(8.74) (9.03) (8.25) (-0.70) (-0.64) (-0.39)

FORIN -549.34 -1016.69 -152.81 -0.10 -0.11 -0.17

(-0.16) (-0.28) (-0.04) (-0.59) (-0.65) (-0.92)

RD -12959.51 -20346.43 -6730.01 5.85** 5.79** 5.00

(-0.19) (-0.28) (-0.1) (2.04) (1.94) (1.42)

LEV -186.36 -205.32 -153.53 -0.01 -0.01 -0.01

(-1.38) (-1.53) (-1.16) (-1.09) (-1.01) (-1.59)

CAPIN 362.49 1205.49 -379.05 0.50 0.50 0.47

(0.11) (0.33) (-0.12) (0.99) (0.93) (0.95)

Constant 300.68 -1064.95 -965.93 1.88*** 1.77*** 1.95***

(0.14) (-0.71) (-0.52) (10.88) (13.44) (12.67)

Random effect Y Y Y Y Y Y

Firm effect N N N N N N

Year effect Y Y Y Y Y Y

No.of obs 304 304 304 304 304 304

R-squared 0.743 0.736 0.745 0.137 0.127 0.0941

Wald 294.33*** 233.25*** 349.31*** 101.75*** 117.22*** 90.68***

*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.

employ data of firms from FTSE All-Share over the period of 1988 to 2014 and show

no link between corporate tax payments and the share price of a firm.

Equation (2) incorporates the interaction variables C_ETR*BI, BTD*BI and PBTD*BI

to test whether corporate governance mitigates the relationship between firm value and

tax avoidance. The results of Equation (2) using a dependent variable, MV and

corporate governance measure, BI, are presented in Table 5. The inclusion of the

corporate governance measure and the interaction term change the direction of the

previous positive relationship between tax avoidance and firm value. The interpretation

is limited since the previous relationships (see Table 4) are insignificant and the

coefficients of the interaction terms are all insignificant either (the results of one-sided

hypothesis test are P= 0.244, 0.167 and 0.412 respectively for the model I, II and III).

But the directions of the coefficients are consistent with H2 that 𝛽C_ETR∗BI is negative,

𝛽BTD∗BI and 𝛽PBTD∗BI are positive. R-squares of the regressions testing H1 and H2 are

similar23 which suggests that the incorporation of corporate governance has little

contribution.

Additional tests are conducted to further analyse the effect of corporate governance.

The whole sample is split into two subsamples of strong and weak corporate governance

firms (Desai and Dharmapala 2006; Desai and Dharmapala 2009; Abdul Wahab and

Holland 2012). Firms are separated by the median of BI at firm-year level. Firms with

high board independence are considered as having a strong corporate governance and

vice versa. For strong corporate governance group, the coefficient of C_ETR on MV is

negative and significant which can be interpreted as every 1% drop in current effective

tax rate resulting in an increase of £11,171.10 million in firm value (Table 5, the model

I). For weak-governed firms, the effect of C_ETR is insignificant and in an inverse

direction. This result is consistent with the findings of Desai and Dharmapala (2009)

and implies that shareholders perceive tax avoidance activities as value-added activities

in terms of well-governance companies but view tax avoidance activities as more risky

investments with regard to poor governance companies. In other words, the relationship

between MV and C_ETR is conditional upon the strength of corporate governance.

The tax avoidance (C_ETR) coefficients in two subsamples are significantly different

from each other (H0: -11171.10=473.19, p=0.043<0.05). The significant difference

between coefficients is robust to tax avoidance measure of BTD (H0: 47256.42=-

18143.99, P=0.050) but sensitive to the measure of PBTD (p=0.284>0.05). According

to the direction of the coefficient (Table 5), there is an inverse relationship between tax

avoidance and corporate governance for two subsamples, which indicates that the

overall effect of tax avoidance across firms may be offset. This result of the subsamples

may explain previous insignificant relationship at an aggregate level (Table 4). In short,

by splitting the sample this paper finds that the relationship between tax avoidance and

firm value tends to be positive for firms with strong corporate governance than for firms

with weak corporate governance, consistent with H2 and US findings of Desai and

Dharmapala (2009).

23 R-squares for model I, II and III in Equation (1) equal to 74.3%, 73.6% and 74.5% respectively (Table 4, column 1, 2 and 3) and R-squares of Equation (2) equal to 74.86%, 73.29% and 74.99% respectively (Table 5, column 1, 2 and 3).

Table 5 Panel regression for the mitigation effect of corporate governance on the relationship between tax avoidance and firm value (measured by Market capitalization) using robust standard

errors clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)

Dependent variable MV

Whole Sample Strong corporate governance Weak corporate governance

Models I II III I II III I II III

C_ETR 1739.83 -11171.10* 473.19

(0.21) (-1.77) (0.25)

C_ETR*BI -99.36

(-0.69)

BTD -16651.10 47256.42 -18143.99

(-0.53) (1.28) (-1.06)

BTD*BI 718.62

(0.97)

PBTD -2960.65 2179.96 -2882.02

(-0.29) (0.33) (-0.49)

PBTD*BI 47.35

(0.22)

BI 49.16 -7.76 26.40

(1.11) (-0.42) (1.19)

SALES 1.94*** 2.00*** 1.95*** 2.15*** 1.72*** 2.19*** 1.36*** 0.72* 1.31***

(9.29) (10.93) (8.41) (13.90) (6.15) (16.04) (4.14) (1.78) (4.28)

FORIN -669.22 -236.98 -290.64 -2951.04 -5563.64 -2994.07 9987.58 12150.93 9690.80

(-0.19) (-0.06) (-0.09) (-1.07) (-0.98) (-1.14) (0.85) (0.95) (0.87)

RD -819.16 -33087.13 2955.81 36725.90 -131454.20 74881.58 -83373.94 -108318.20 -77734.59

(-0.01) (-0.56) (0.05) (0.63) (-0.95) (1.37) (-0.72) (-0.90) (-0.70)

LEV -178.39 -161.74 -150.52 -257.46 -225.03 -212.59 407.93 547.52 447.28

(-1.33) (-1.07) (-1.18) (-1.51) (-1.33) (-1.32) (0.85) (0.86) (0.90)

CAPIN -168.05 1852.54 -755.59 3911.26 512.93 2618.12 -3029.85 -3877.14 -2853.12

(-0.05) (0.46) (-0.21) (0.80) (0.12) (0.47) (-0.81) (-0.85) (-0.81)

Constant -2559.91 -1310.59 -2536.57 3055.71 5699.73 963.42 -4054.57 -2872.41 -3866.98

(-0.95) (-0.80) (-1.47) (0.82) (1.53) (0.29) (-1.15) (-1.04) (-1.17)

Random effect Y Y Y Y N Y Y Y Y

Firm effect N N N N Y N N N N

Year effect Y N Y N N Y N Y Y

No.of obs 304 304 304 152 152 152 152 152 152

R-squared 0.7486 0.7329 0.7499 0.8681 0.8079 0.8658 0.4133 0.4672 0.4287

F-statistic/Wald 401.16*** 209.32*** 453.91*** 1338.84 *** 163.40*** 28193.84*** 25.33*** 88.07*** 19.58***

*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.

Furthermore, Equation (2) is also tested by an alternative dependent variable, Tobin’s q

(Table 6). Similar to previous findings, the results of the whole sample show little

evidence in supportive of the hypothesis. The coefficients of the tax avoidance

measures (C_ETR, BTD) and the interaction terms (C_ETR*BI, BTD*BI) are all

statistically insignificant when q is used as the proxy for firm value. In terms of model

III, given that the PBTD shows a positive impact and BI shows a negative impact on

Tobin’s q, the interaction terms PBTD*BI is significantly and negatively associated

with Tobin’s q which contradicts to the notion of agency theory.

The separation of the whole sample by strong and weak corporate governance firms

shows robust findings as previous results of subsamples (Table 6, strong and weak

corporate governance panel). There is a significant and positive relationship between

tax avoidance level and firm value for strong corporate governance firms and the

relationship is robust to different tax avoidance proxies24. In terms of weak corporate

governance firms, the coefficients of C_ETR and BTD imply that the relationship

between tax avoidance proxy and Tobin’s q is statistically insignificant. By comparing

the coefficients in two groups, this paper finds a significant difference (at 10% level) of

the coefficient of C_ETR between strong and weak corporate governance samples.

There is an exemption that the coefficient of PBTD in weak corporate governance group

is significant and positive. The previous positive and significant relationship between

Tobin’s and PBTD (Table 4) still holds for both groups of corporate governance strength.

Comparing the R-square of models using MV with those using q, the result shows a

significant drop in magnitude. It could be concluded that instead of using q as an

alternate dependent variable to test the robustness of the result, the inclusion of q is

problematic. It leads to models having little explanatory power. In addition, the result

of control variables shows inconsistency with previous findings.

Corporate governance score (CG) as another measure of corporate governance is also

used to test Equation (2) (Table 7) in addition to board independence (BI). The results

of Equation (2) are consistent with previous findings that at an aggregate level, there is

no significant impact of corporate governance on the relationship between tax

avoidance and firm value. R-squared for all the regressions using CG as the proxy of

corporate governance, are higher than the R-squared of regressions using BI (Table

4&5). The increase in R-squared indicates that the measure of CG has better

explanatory power in the model.

With regard to the test of H3, the following section conducts multivariate analysis to

test the sensitivity of tax avoidance to various corporate governance mechanisms. Table

8 reports the estimation results of Equation (3) and the results after controlling for

endogeneity problem which commonly occurs in corporate governance research. Noted

that diagnostics tests are used to decide whether to include random or fixed effect within

the regression and whether time fixed effect is needed (see Appendix 2). Following

Wintoki et al. (2012) and Minnick and Noga (2010), this paper controls for the

endogeneity by including lags of the main variable of interest. Prior literature suggest

that past performance is useful in measuring the historical managerial performance as

well as predicting the future governance features (Minnick and Noga 2010). Thus using

a lagged variable is argued to be the most appropriate approach to control for the

endogeneity problem (Wintoki et al. 2012). 24 The null hypothesis that tax avoidance is positively related to firm value is one-sided test, e.g.H0: β𝐶_𝐸𝑇𝑅 < 0, H0: β𝐵𝑇𝐷 > 0 and H0: β𝐵𝑇𝐷 > 0. The results is p=0.039<0.05, p=0.082<0.10 and p=0.022<0.05 respectively.

Table 6 Panel regression for the mitigation effect of corporate governance on the relationship between tax avoidance and firm value (measured by Tobin’s q) using robust standard

errors clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)

Dependent variable Tobin’s q

Whole Sample Strong corporate governance Weak corporate governance

Models I II III I II III I II III

C_ETR -0.72 -0.97* -0.09

(-0.84) (-1.88) (-0.47)

C_ETR*BI 0.01

(0.57)

BTD 0.00 1.87* 0.27

(0.00) (1.40) (0.11)

BTD*BI 0.02

(0.50)

PBTD 2.56*** 1.22*** 2.67**

(2.92) (2.02) (2.10)

PBTD*BI -0.02*

(-1.78)

BI -0.01 0.00 -0.01**

(-1.43) (-1.56) (-2.15)

SALES 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

(-0.82) (-0.81) (-0.66) (-1.57) (-1.33) (-1.26) (0.43) (0.45) (1.01)

FORIN -0.07 -0.08 -0.10 -0.11 -0.03 -0.12 -0.35 -0.34 -0.26

(-0.41) (-0.46) (-0.55) (-0.48) (-0.15) (-0.56) (-1.39) (-1.40) (-0.57)

RD 4.60 4.40 3.46 -21.68 3.62 3.24 4.99 5.01 -5.90

(1.50) (1.44) (0.95) (-1.44) (0.58) (0.43) (1.01) (0.97) (-0.57)

LEV -0.01 0.00 -0.01** -0.01 -0.01* -0.01*** 0.05 0.05 0.01

(-1.24) (-1.04) (-2.27) (-1.32) (-1.81) (-2.34) (0.86) (0.88) (0.25)

CAPIN 0.59 0.61 0.56 1.11 0.78 0.80 0.17 0.17 -0.37

(1.15) (1.12) (1.13) (1.04) (0.91) (1.05) (0.26) (0.25) (-1.20)

Constant 2.15*** 1.96*** 2.23*** 2.35*** 2.01*** 2.19*** 1.57*** 1.54*** 1.81***

(7.53) (10.39) (9.39) (7.41) (8.60) (9.47) (7.36) (8.43) (7.77)

Random effect Y Y Y N Y Y Y Y N

Firm effect N N N Y N N N N Y

Year effect Y Y Y N Y Y Y Y Y

No.of obs 304 304 304 152 152 152 152 152 152

R-squared 0.1218 0.1133 0.1026 0.0013 0.1128 0.0956 0.2083 0.2076 0.0447

F-statistic/Wald 126.44*** 136.35*** 121.54*** 1.56 90.20*** 88.89*** 280.92*** 359.23*** 7.54***

*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.

Table 7 Panel regression for the mitigation effect of corporate governance (measured by corporate

governance score) on the relationship between tax avoidance and firm value using robust standard errors

clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)

Dependent variable MV Tobin’s q

Models I II III I II III

C_ETR 11150.59 -1.12

(0.53) (-0.59)

C_ETR*CG -186.44 0.01

(-0.66) (0.39)

BTD -39229.76 -5.10

(-0.55) (-0.96)

BTD*CG 916.73 0.09

(0.86) (1.15)

PBTD 20461.93 2.84

(1.19) (1.44)

PBTD*CG -251.66 -0.02

(-1.45) (-0.67)

CG -33.08 -76.17*** -109.54*** -0.01 0.00 -0.01

(-0.42) (-3.30) (-3.04) (-0.83) (-1.14) (-1.46)

SALES 1.89*** 1.90*** 1.91*** 0.00 0.00 0.00

(9.44) (9.97) (9.05) (-0.73) (-0.70) (-0.41)

FORIN -583.34 -1053.51 -447.90 -0.11 -0.11 -0.19

(-0.17) (-0.30) (-0.13) (-0.62) (-0.63) (-1.01)

RD -7701.09 -19821.59 1046.46 6.09** 5.61* 5.25

(-0.11) (-0.27) (0.02) (2.14) (1.91) (1.49)

LEV -173.04 -204.96 -157.29 -0.01 -0.01 -0.01*

(-1.37) (-1.60) (-1.21) (-1.17) (-1.08) (-1.70)

CAPIN 355.43 1096.89 -1143.96 0.51 0.51 0.43

(0.11) (0.31) (-0.36) (0.99) (0.95) (0.83)

Constant 1908.06 4357.33 7102.47* 2.34*** 2.00*** 2.35***

(0.33) (1.63) (1.72) (4.02) (9.19) (6.57)

Random effect Y Y Y Y Y Y

Firm effect N N N N N N

Year effect Y Y Y Y Y Y

No.of obs 304 304 304 304 304 304

R-squared 0.7561 0.7474 0.7555 0.1559 0.1479 0.1091

F-statistic 471.72*** 343.83*** 446.96*** 112.46*** 162.39*** 103.11***

*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.

With regard to board structure, board size is found to be negatively related to PBTD

and the result is robust after controlling for endogeneity (Table 8). The coefficient of

BS is statistically significant which implies that to add 1 more person to the board leads

to PBTD decrease by 1% of the total assets. The findings are consistent with the

evidence of Cheng (2008) that larger board is related to more stable firm value. There

is a weak but significant relationship between CCD and tax avoidance measures,

indicating that a firm has a lower level of tax avoidance if the CEO and the chair of the

board are two different people. This result contradicts to previous US findings of

Minnick and Noga (2010) and the notion that stronger corporate control relates to lower

tax liabilities since firms may have a higher level of monitoring for tax avoidance

strategies. OSTR has significant coefficients but the effect of OSTR on tax avoidance

is weak since the magnitude of the coefficient converges to zero. Among all the

corporate governance characteristics, incentives compensation appears to have the

strongest effect in driving the decision of corporate tax avoidance strategies. The

coefficient of CEOC is significant for both C_ETR and BTD.

In terms of CEO compensation, on average firms with CEO compensation relating to

stock returns (CEOC) result in a lower C_ETR and higher BTD. The result is consistent

with H3 that stronger corporate governance aligns the interests of managers with the

interests of all the shareholder’s. According to Table 8, total senior managerial

compensation (TOMP) has a slightly positive and significant relationship with PBTD.

This result is consistent with the notion that higher compensation leads to fewer

incentives for manager extracting rents. Overall, the empirical results show that

incentives compensation is most sensitive to the decision of corporate tax avoidance

level. Higher corporate governance imposes stronger internal control which aligns the

interest of managers with the interest of shareholders. However, according to the

regression result of Equation (3), corporate governance characteristics some of which

have an uncertain effect on firm performance appear to have a various effect on tax

avoidance. According to the findings of this paper, larger BS and the separation of

CEO/Chair lead to lower level of tax avoidance. On the other hand, compensation

incentives encourage managers to get more involve in tax avoidance activities (Rego

and Wilson 2012; Minnick and Noga 2010; Kubick and Lockhart (2016).

Table 8 Panel regression for the effect of corporate governance characteristics on tax avoidance activities using

robust standard errors clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)

Dependent

variables C_ETR BTD PBTD C_ETR BTD PBTD

Models Equation (3) Equation (3) controlled for endogeneity

CG 0.00*** 0.00*** 0.00 0.00 -0.02 0.00

(-3.03) (3.30) (0.38) (-0.59) (-2.30) (0.26)

BS 0.01 0.00* -0.01** 0.00 0.04 -0.01**

(1.18) (-1.82) (-2.43) (-0.51) (2.40) (-2.19)

BI 0.00 0.00 0.00 0.00 0.01 0.00*

(1.10) (-1.46) (-1.53) (0.69) (1.90) (-1.97)

CCD 0.04** -0.03*** -0.01 0.04 0.00** -0.01

(2.25) (-3.80) (-0.69) (1.28) (0.02) (-0.21)

OSTR 0.00** 0.00** 0.00* 0.45 0.00** -0.01

(-2.30) (2.10) (1.89) (1.64) (-0.68) (-0.15)

CEOC 0.01 0.00 0.04* -0.07** 0.03* 0.02

(0.60) (0.00) (1.69) (-2.42) (1.63) (0.97)

TCOMP 0.00 0.00 0.00* 0.00 0.53 0.00*

(-0.17) (-0.18) (-1.81) (-1.19) (1.35) (-1.79)

SALES 0.00 0.00 0.00 0.00 0.00 0.00

(0.44) (-0.68) (0.24) (0.66) (2.49) (-0.18)

FORIN -0.03 0.01 -0.03 -0.20* -0.02 -0.02

(-0.97) (1.21) (-0.57) (-1.86) (-0.40) (-0.29)

RD 0.88 -0.16 -0.23 -1.46 -0.02 -1.33

(1.36) (-0.71) (-0.23) (-1.06) (-2.30) (-0.83)

LEV -0.01*** 0.00*** 0.00*** -0.01** 0.04** 0.01***

(-3.43) (3.87) (2.80) (-2.68) (2.40) (2.72)

CAPIN 0.01 0.00 0.07 0.05 0.01 0.23*

(0.21) (-0.25) (0.91) (0.31) (1.90) (1.87)

𝐂_𝐄𝐓𝐑𝒕−𝟏 -0.11

(-1.01)

𝐂_𝐄𝐓𝐑𝒕−𝟐 -0.08

(-1.30)

𝐁𝐓𝐃𝒕−𝟏 0.12

(0.66)

𝐁𝐓𝐃𝒕−𝟐 -0.01

(-0.07)

𝐏𝐁𝐓𝐃𝒕−𝟏 0.23

(1.30)

𝐏𝐁𝐓𝐃𝒕−𝟐 -0.08

(-0.61)

Constant 0.35*** -0.05* -0.01 -28.15 -2.42** 0.54

(5.21) (-1.89) (-0.06) (-1.61) (-2.43) (0.21)

Random effect Y Y Y N N N

Firm effect N N N Y Y Y

Year effect Y N N Y N N

No.of obs 152 152 152 152 152 152

R-squared 0.2134 0.3265 0.0827 0.0129 0.0773 0.0171

F-statistic/Chi-

statistic 71.02*** 105.49*** 43.88*** 7.17*** 4.53*** 5.23***

*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.

6. Conclusion

This study conducts an examination under UK setting and it analyses the shareholders’

valuation on tax avoidance activities and the mitigation effect of corporate governance.

The empirical results show no significant relationship between various tax avoidance

proxies and firm value, which is in contrast to the previous US evidence. However, the

findings of Equation (1) are consistent with recent UK evidence by Brooks et al. (2016).

Under agency framework, tax avoidance can lead to higher firm value for strong

corporate governance firms and result in lower firm value for weak governance firms.

This paper then examines the role of corporate governance, whether corporate

governance eliminates agency costs and affects the relationship between tax avoidance

and firm value. The result of this paper shows that corporate governance has the

mitigation effect on the agency problems relating to tax avoidance at a disaggregate

level. By splitting the whole sample into strong corporate governance group and weak

corporate governance group, this paper finds that the relationship between tax

avoidance and firm value tends to be positive for firms with strong corporate

governance and less significant for firms with weak corporate governance. The

empirical result also shows that incentives compensation is most sensitive to the

decision of corporate tax avoidance level. The characteristics of board structure are

effective in controlling for managers’ action regarding tax avoidance strategies.

Although this paper does not find any negative relationship between tax avoidance and

firm value, one reason may be that tax avoidance measures of current ETR, BTD and

PBTD could impose measurement error since taxes is not often a dominant factor of a

decision. Other determinants e.g. earnings management may affect the quality of tax

avoidance measures. Another reason may be attributed to the changing attitude of tax

avoidance in the UK environment. The general public is expecting more transparency

and social responsibility for business activities and tax management, which indicates

that the reputation costs for corporate tax avoidance behaviours are increasing. Large

businesses are more likely to react according to their social responsibility. This paper

may thus have sample bias since it employs the data from the UK’s largest 350 firms

listed on London Stock Exchange. Therefore, instead of limiting to the shareholders’

aspect of tax avoidance valuation effect, perhaps future research could explore other

groups of interest in affecting the tax avoidance decisions. In terms of agency costs that

tax avoidance may incur, the purpose of increased corporate governance is to maximize

shareholders’ wealth, and different corporate governance mechanisms may result in

different effect on tax avoidance. As shown in the empirical findings, the overall effect

of corporate governance on the relationship between tax avoidance and firm value can

be insignificant. However, the dynamic nature of the interplay between corporate

governance mechanisms and tax avoidance suggests that future research could explore

focusing on the various effect between corporate governance and corporate tax

avoidance decisions.

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