Financial Management - 2017 - Bayar - Corporate Governance Tax Avoidance and Financial Constraints

Corporate Governance, Tax Avoidance,
and Financial Constraints

Onur Bayar, Fariz Huseynov, and Sabuhi Sardarli∗
We examine how corporate governance affects the relationship between corporate tax avoidance
and financial constraints. Conditional on having poor governance, tax avoidance is associated
with greater financial constraints and a greater likelihood of financial distress. In firms with
strong governance, however, we find that tax avoidance does not have a negative impact on
financial constraints. Our results suggest that tax avoidance is a less useful source of financing for
constrained firms when they are plagued with potential agency problems and opaque information
environments. Stronger governance mechanisms can help firms mitigate the negative consequences
of tax avoidance.
We examine how corporate governance affects the relationship between a firm’s tax avoidance
behavior and its financial constraints.1 A growing stream of finance and accounting literature
has investigated how firms can use corporate tax avoidance as a source of financing for their
investment opportunities in response to greater financial constraints.2 However, so far, the extant
literature has not explored the potentially important effect of managerial incentives and corporate
governance on the endogenous relation between corporate tax avoidance and financial constraints.
Our objective is to fill this gap in the literature by analyzing whether the impact of corporate tax
avoidance on financial constraints depends on the quality of a firm’s governance mechanisms
and whether shareholders can properly discipline their managers to increase the value efficiency
of tax avoidance. Further, we distinguish between fiscally responsible tax management and more
aggressive tax sheltering, and investigate which forms of tax avoidance strategies firms can
effectively use to relax their financial constraints depending on the quality of their governance
mechanisms.
In the wake of major corporate scandals in the early 2000s and the global financial crisis of
2007–2009, there has been a growing interest regarding research examining the consequences
We are grateful to conference participants at the 2015 Midwestern Finance Association meetings and the 2016 Financial
Management Association meetings for helpful comments and discussions. Special thanks to an anonymous referee and
Raghavendra Rau (Editor) for their helpful comments and suggestions. We alone are responsible for any errors or
omissions.
∗
Onur Bayar is an Associate Professor of Finance in the College of Business at the University of Texas in San Antonio,
TX. Fariz Huseynov is an Associate Professor of Finance in the College of Business at North Dakota State University
in Fargo, ND. Sabuhi Sardarli is an Assistant Professor of Finance in the College of Business Administration at Kansas
State University in Manhattan, KS.
1
We use the terms tax planning and tax avoidance interchangeably to describe all actions taken by managers to reduce the
cash tax liabilities of their firm. Throughout the study, tax management refers to regular fiscally responsible tax planning
strategies that are in full compliance with tax laws, whereas tax sheltering refers to more aggressive tax planning strategies
resulting from aggressive interpretations of ambiguous areas within the tax laws. Shackelford and Shevlin (2001) and
Hanlon and Heitzman (2010) review the literature on the determinants of a firm’s tax avoidance behavior.
2
The survey evidence of Graham et al. (2014) suggests that financially constrained firms are more likely to manage their
taxes to obtain cash savings. Law and Mills (2015) find that financially constrained firms pursue more aggressive tax
planning strategies. In a concurrent study, Edwards, Schwab, and Shevlin, 2016 find that firms facing increased financial
constraints exhibit decreases in cash effective tax rates (ETRs).
Financial Management • Fall 2018 • pages 651 – 677
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652 Financial Management r Fall 2018
of tax avoidance from a governance perspective. While outside investors may recognize tax
management as a value-increasing activity for a financially constrained firm, more aggressive tax
avoidance practices may also be associated with increased opportunities for rent diversion by the
firm’s managers. Slemrod (2004), Crocker and Slemrod (2005), and Desai and Dharmapala (2006,
2009) argue that corporate tax avoidance cannot be simply viewed as a transfer of wealth from
the government to firm shareholders in the presence of agency problems between shareholders
and managers. Because tax avoidance usually implies the need to engage in actions that obscure
the underlying intent of the transaction, it can simultaneously provide a shield for managers
engaging in a variety of diversionary activities that increase their payouts at the expense of
shareholders.3
When firms have weak governance mechanisms, corporate tax avoidance is likely to coincide
with more opaque information environments in which entrenched managers divert firm resources
for their own private benefits, manipulate earnings, and hoard bad news about the firm (Lev
and Nissim, 2004; Hanlon, 2005; Hanlon and Heitzman, 2010). In addition to direct costs of
tax planning (administrative costs, litigation expenses, and penalties imposed by tax authorities),
aggressive tax avoidance activities, such as tax sheltering, may involve substantial indirect costs
including potential reputation losses, political costs, a greater cost of debt, and a higher stock
price crash risk (Hanlon and Slemrod, 2009; Wilson, 2009; Kim, Li, and Zhang, 2011; Graham
et al., 2014; Hasan et al., 2014). Hence, we predict that conditional on poor corporate governance,
greater tax avoidance will be associated with increased financial constraints and a greater risk of
financial distress.
In contrast, when the interests of managers and shareholders are properly aligned, efficient tax
management can provide a net positive value to the firm’s shareholders. If the marginal cost of
tax avoidance is sufficiently small, additional internal cash flows generated by tax avoidance may
reduce the firm’s financial constraints and the risk of financial distress.4 Graham and Tucker
(2006) argue that tax planning using tax shelters is a value-enhancing activity that substitutes
for debt-induced tax deductions, which could enhance credit quality and reduce the cost of debt.
However, Desai and Dharmapala (2009) show a positive relation between firm value and tax
avoidance only within a subsample of well-governed firms.5 Strong governance mechanisms
with properly structured managerial incentive schemes can ensure the positive value effect of
tax avoidance by disciplining the firm’s managers against managerial rent diversion and earnings
manipulation. Therefore, we predict that conditional on strong governance, greater tax avoidance
will not be associated with increased financial constraints.
We recognize that the causality of the relation between corporate tax avoidance and financial
constraints may operate in both directions. By focusing on the impact of corporate tax avoidance
on financial constraints, our study differs importantly from the prior literature that investigates
how financial constraints affect a firm’s tax avoidance behavior (Law and Mills, 2015; Edwards
et al., 2016). Because simultaneous causality may lead to biased ordinary least squares (OLS)
estimators, we conduct a two-staged least squares (2SLS) analysis with instrumental variables
to better identify the impact of tax avoidance on financial constraints conditional on governance
3
Several high-profile corporate scandals at the turn of the century, such as Enron (see Desai and Dharmapala, 2009),
Dynegy (see Desai and Dharmapala, 2006), and Tyco (see Desai, 2005), involved tax avoidance, tax sheltering, earnings
manipulations, and accounting fraud or managerial theft. Desai, Dyck, and Zingales (2007) analyze the interaction
between corporate taxes and corporate governance, and how this interaction affects the level of managerial diversion.
Mironov (2013) shows that managerial diversion causes a negative relation between tax evasion and firm performance.
4
Mills (1998) finds that an additional $1 investment in tax planning results in a $4 reduction in tax liabilities.
5
Minnick and Noga (2010) find that higher pay performance sensitivity provides better managerial incentives for tax
management that increases firm value.
Bayar, Huseynov, & Sardarli r Corporate Governance, Tax Avoidance, and Financial Constraints 653
6
quality. Following Dyreng, Hanlon, and Maydew (2008), we define tax avoidance as the reduction
in the firm’s taxes relative to its pretax accounting income. We use the long-run cash effective tax
rate (Cash ETR) as our measure of tax avoidance. We infer that a lower (higher) ETR indicates
a higher (lower) incidence of corporate tax avoidance. Following Boone, Khurana, and Raman
(2013) and Hasan et al. (2014), we use religiosity (defined as the fraction of population in the
county of the firm’s corporate headquarter that claims affiliation with an organized religion) and
the three-digit Standard Industrial Classification (SIC) industry median value of Cash ETR as
instruments for tax avoidance. While ETR measures can reflect all tax planning activities across
the entire spectrum of tax avoidance, we assume that they represent the outcomes of regular,
fiscally responsible tax management activities. Therefore, to measure tax aggressiveness or tax
sheltering specifically, we use the tax sheltering measure developed by Wilson (2009). Following
Hasan et al. (2017), we use social capital surrounding the corporate headquarters location as
an instrument to identify the effect of tax sheltering on financial constraints. We measure the
degree of a firm’s financial constraints, WWscore, by using a proxy developed by Whited and Wu
(2006). To classify firms into groups of strong governance and poor governance, respectively,
we rely on a variety of measures to capture the strength of a firm’s governance mechanisms,
such as the entrenchment index of Bebchuk, Cohen, and Ferrell (2009), institutional ownership,
incentive-based compensation, and board-independence measures.
We start our empirical analysis by identifying the impact of corporate tax avoidance on firms’
financial constraints in a 2SLS multivariate regression framework. Results over the full sample
show that firms with greater tax avoidance (as measured by lower Cash ETRs) and firms that
engage in tax sheltering face greater financial constraints (higher WWscore) on average. Because
the marginal impact of corporate tax avoidance on a firm’s financial constraints may differ
depending on the level of a firm’s existing level of financial constraints, we also examine
this relation conditional on the level of these constraints. We divide the sample firms into
constrained and unconstrained subsamples based on the median value of WWscore and run the
2SLS regression model for the impact of tax avoidance on financial constraints for each of
these groups separately. Our results show that in the subsample of constrained firms, both tax
management (lower Cash ETR) and tax sheltering (higher sheltering probability) are associated
with greater financial constraints. This result is consistent with the notion that outside investors
may perceive tax avoidance or tax sheltering as a risky managerial strategy during periods of
financial constraints (distress). In contrast, conditional on a firm being unconstrained, we find
that neither tax avoidance nor tax sheltering has a significant impact on financial constraints.
The next step in our empirical analysis is to identify the impact of corporate governance on the
relation between corporate tax avoidance and financial constraints. We divide the sample firms
into strong governance and poor governance groups based on the median value of the particular
governance variable we use (namely, entrenchment index, institutional ownership, incentive-based
compensation, board independence). Our findings indicate that the impact of tax management
and tax sheltering on financial constraints depends on the level of governance. In particular, we
find that in firms with poor governance, both tax management and tax sheltering are uniformly
associated with increased financial constraints (higher WWscore) across all governance measures.
In contrast, we find that the impact of tax management and tax sheltering on financial constraints
is mixed with weakly significant results and the sign of the impact varies with governance
measures in firms with strong governance. Overall, our results indicate that corporate governance
moderates the impact of tax planning on financial constraints: tax avoidance is likely to compound
6
For the econometric method used in our study, see also O’Brien and Bhushan (1990), Alford and Berger (1999), and
Hong, Huseynov, and Zhang (2014).
the financial constraints of firms with poor governance mechanisms, whereas it does not have a
negative impact on firms with stronger governance mechanisms.
We contribute to the literature in several ways. First, by taking an agency perspective, our study
complements the recent literature on financial constraints and tax avoidance (Law and Mills,
2015; Edwards et al., 2016) and the role of corporate governance in increasing firm value through
tax avoidance (Desai and Dharmapala, 2006, 2009; Minnick and Noga, 2010). Conditional on
poor governance, we find that tax avoidance is associated with greater financial constraints and
a greater likelihood of financial distress. Tax avoidance (in all different forms) is a less useful
source of financing in financially constrained firms that are plagued with agency problems and
opaque information environments. These results also shed light on the “undersheltering puzzle”
(Weisbach, 2002) suggesting that the potential increase in financial constraints may discourage
poorly governed firms from exploiting their tax avoidance strategies to the fullest extent.
Second, our paper extends the literature investigating the impact of corporate governance on the
tax avoidance behavior of firms. Khan, Srinivasan, and Tan (2017) and Bird and Karolyi (2017)
find that positive shocks to institutional ownership lead to significant increases in tax avoidance
activities. They conclude that improved monitoring by institutional ownership increases the value
efficiency of avoiding taxes. Our findings complement their results by suggesting that in firms
with strong governance, the potentially negative effects of tax avoidance on financial constraints
may be offset by having strong governance mechanisms in place.
Third, our study contributes to the corporate finance literature examining the effect of costly
external financing on corporate financial and investment policies. Capital market imperfections
increase the cost of external financing relative to internally generated funds (see, e.g., Myers
and Majluf, 1984). Faulkender and Wang (2006), Pinkowitz, Stulz, and Williamson (2006), and
Denis and Sibilkov (2010) find that cash holdings are more valuable for constrained firms than
for unconstrained firms. Our study shows that both tax management and tax sheltering are
associated with greater financial constraints in constrained firms with poor governance, whereas
tax avoidance by firms with strong governance does not necessarily result in greater financial
constraints.
The remainder of this paper is organized as follows: Section I discusses data sources, the sample
selection, and the research methodology. Section II presents and discusses our main empirical
results. Section III presents the findings of supplemental robustness tests. Section IV concludes
the paper.
I. Data, Variables, and Research Design
The data used in this study primarily come from four publicly available data sources. We
obtain the financial statement data from Compustat and complement it with additional gover-
nance variables constructed from Institutional Shareholder Services (ISS, formerly RiskMetrics),
Execucomp, and Thomson Institutional Holdings databases. Consistent with prior tax planning
studies, we drop firm-year observations with missing total assets and those with missing or non-
positive pretax income because they are treated differently for tax purposes. We also eliminate
financial firms and utility firms (SIC codes 4000–4999 and 6000–6999). Our final data set
includes more than 35,000 firm-year observations from 1990 to 2015.
A. Financial Constraints, Tax Avoidance, and Governance Measures

We use a single measure of financial constraints and two measures of tax avoidance suggested
by the prior literature. Our measure of financial constraints is WWscore, a firm-year-specific
financial constraint index developed by Whited and Wu (2006) and widely used by previous
studies (e.g., Duchin, 2010; Li, 2011; Panousi and Papanikolaou, 2012). WWscore is calculated
as follows and coded such that higher values represent tighter financial constraints:7
WWscore = − 0.091CFit − 0.062 DIVPOSit + 0.021 LTDEBTit − 0.044 LNTAit

+ 0.102 ISGit − 0.035 SG it . (1)
Following Dyreng et al. (2008), we define tax avoidance broadly to encompass all actions
that reduce a firm’s taxes relative to its pretax accounting income. We use two measures of tax
avoidance to capture the extent of fiscally responsible tax management and more aggressive tax
sheltering activities. Our measure of tax management is the long-run cash ETR, Cash ETR, which
is the most direct measure of a firm’s cash tax burden. The long-run Cash ETR is estimated as
the five-year-centered moving sum of cash paid for income taxes over five years scaled by the
moving sum of pretax income (net of special items) over the same period (see Dyreng et al.,
2008). This generates an effective cash tax rate that more closely tracks the firm’s tax costs over
the long run, and it avoids year-to-year volatility in annual ETRs. We assume that firms that avoid
taxes more (less) will have lower (higher) ETRs.
Our measure of tax sheltering was constructed by Wilson (2009) to estimate the propensity of
firms to engage in tax sheltering, which captures particularly aggressive forms of tax avoidance
practices.8 We follow Rego and Wilson (2012), Hoi, Wu, and Zhang (2013), and Khurana and
Moser (2013) and construct a dummy variable, Shelter, that equals one if a firm’s estimated
shelter probability belongs to the top quartile and zero otherwise.
We use four different measures to proxy for the quality and the strength of a firm’s governance
mechanisms. E-Index (entrenchment index) of Bebchuk et al. (2009) is a measure of managerial
power and entrenchment. Institutional Ownership is the fraction of a firm’s common equity owned
by institutional investors and is a measure of external monitoring by institutional investors. Board
Independence is the fraction of independent board members in a firm’s board of directors.
Delta, which is defined as the percentage change in chief executive officer’s (CEO’s) wealth
for 1% increase in stock price (logarithmic transformation), is a measure of incentive-based
compensation and a proxy for the alignment of the interests of managers and shareholders
(Core and Guay, 2002; Coles, Daniel, and Naveen, 2006). Consistent with the prior literature, we
consider lower values of E-Index, higher values of Institutional Ownership, higher values of Board
Independence, and higher values of Delta as indicative of stronger (better) governance and vice
versa.
B. Determinants of Financial Constraints

We control for several firm-specific characteristics, which the finance and accounting literatures
have shown to affect firms’ financial constraints. Because more profitable firms are less likely
7
In this equation, CF is the ratio of cash flow to total assets; DIVPOS is an indicator that takes the value of one if the firm
pays cash dividends; LTDEBT is the ratio of the long-term debt to total assets; LNTA is the natural log of total assets; ISG
is the firm’s three-digit SIC industry sales growth; and SG is firm sales growth.
8
Shelter probability is computed by using the following model obtained from logit model regression estimates reported
in Table V (Column (1)) of Wilson (2009): Shelter Prob. = –4.30 + 6.63 × BTD – 1.72 × Lev + 0.66 × Size + 2.26
× ROA + 1.62 × Foreign Income + 1.56 × RD; where BTD is the book tax difference, Lev is the long-term debt scaled
by total assets; Size is the log of total assets; ROA is the net-income scaled by total assets; Foreign Income is a dummy
variable, coded one for firms with foreign income and zero otherwise; and RD is the research and development (R&D)
expenditure scaled by total assets.
to be financially constrained, we control for firm profitability by using Return on Assets (the
ratio of firms’ pretax income to total assets). Prior literature (e.g., Faulkender and Wang, 2006;
Denis and Sibilkov, 2010) finds a positive association between a firm’s cash holdings and its
financial constraints. Financially constrained firms may hold more cash to reduce the need for
costly external financing, especially when they expect their future cash flows to be insufficient to
cover future investment requirements. We control for this by using cash holdings scaled by total
assets, Cash Holdings, as another control variable.
We expect firms with greater growth opportunities and larger capital expenditures to be more
financially constrained, as they require more funds for their investments (Korajczyk and Levy,
2003). We use three variables—Market to Book ratio, calculated as the ratio of market value
of equity to the book value of equity; Capital Expenditures, defined as the ratio of capital
expenditures to total assets; and Net Working Capital, calculated as net working capital (less
cash) divided by total assets—to control for a firm’s investments requirements. We also control
for the possibility of investment inefficiency in a firm due to managerial moral hazard. Firms with
more inefficient investments are more likely to face greater financial constraints (Subramaniam
et al., 2011). Following Subramaniam et al. (2011), we define Inefficiency as the interaction
between capital expenditures scaled by total assets and a dummy variable that is one if a firm’s
Tobin’s Q is lower than the industry’s median, and zero otherwise.9
An opaque information environment and the lack of transparency in financial reporting gen-
erally increase the cost of external financing (Francis, Khurana, and Pereira, 2005). Higher
accounting quality also enhances the firm’s investment efficiency by reducing the information
asymmetry between firm insiders (management) and the firm’s outside investors (Biddle and
Hilary, 2006). The negative impact of disclosure on the cost of capital is more likely to be driven
by higher earnings quality. Francis, Nanda, and Olsson (2008) find that good earnings quality
has a larger impact on the costs of external financing than other forms of financial disclosure.
Following prior studies, such as Hong, Huseynov, and Zhang (2014), we estimate the absolute
value of discretionary accruals, Discretionary Accruals, using the performance-controlled cross-
sectional modified Jones (1991) model to control for aggressive financial reporting practices
(see, e.g., Kothari, Leone, and Wasley, 2005). Larger values of Discretionary Accruals signal
higher earnings management and lower earnings quality.
C. 2SLS Method and Instruments

Our paper focuses on the impact of corporate tax avoidance on financial constraints. However,
the causality of the relation between corporate tax avoidance and financial constraints may operate
in both directions, and the prior literature has examined the effect of financial constraints on a
firm’s tax planning behavior. Therefore, a simple OLS methodology of examining the effect of tax
avoidance on financial constraints would result in biased estimators due to the simultaneity bias
and endogeneity.10 To control for potential endogeneity in this relation due to reverse causality, we
use 2SLS with instrumental variables. In the first-stage regressions, we predict the tax avoidance
measures using instruments and control variables as follows:
9
The Tobin’s Q ratio is calculated as the book value of assets less the book value of equity plus the market value of the
equity, divided by the book value of the assets.
10
According to a methodology outlined by Wooldridge (2015), the simultaneity bias has the same sign as α2 /(1 − α1 α2 ),
where α1 and α2 are coefficients from two separate OLS regressions where WWscore and tax avoidance variables (Cash
ETR or Shelter) are alternated as dependent and independent variables. We determine that OLS estimator would be biased
downward, as this simultaneity bias is attenuating both in Cash ETR and Shelter results.
Tax Avoidancei,t = γ0 + ∝1 Instrument j,t + γ1 Return on Assetsi,t + γ3 Cash holdingsi,t
+ γ4 Market to Booki,t + γ5 Net Working Capitali,t + γ6 Capital Expendituresi,t

+ γ7 Inefficiencyi,t + γ8 Discretionary Accrualsi,t . (2)
In Equation (2), Tax Avoidance is one of two tax avoidance measures: Cash ETR or Shelter.
Instrumental variables chosen for each measure are distinct and discussed separately. For Cash
ETR, we have identified two instruments that are used together in the first-stage regression. The
first instrument is Religiosity, defined as the fraction of population in the county of the firm’s
headquarters that have an affiliation with an organized religion. Consistent with the broader
literature stream that suggests that religion-based social norms can serve as a mechanism for
influencing corporate decision making (e.g., Hilary and Hui, 2009; Grullon, Kanatas, and Weston,
2010; Dyreng, Maydew, and Williams, 2012; McGuire, Omer, and Sharp, 2012), Boone et al.
(2013) document that firms located in counties with higher Religiosity are less likely to engage
in tax avoidance. Therefore, we expect this instrument to have a positive and strong relation with
Cash ETR. We obtain the data for Religiosity variable from surveys conducted by the Association
of Religion Data Archives (ARDA) and match the county-level data to the county in which the
firm’s headquarters is located using postal zip codes. Specific data items from ARDA surveys
are collected from Churches and Church Membership files conducted in 1990, 2000, and 2010.
Following both Boone et al. (2013) and Hasan et al. (2014), we linearly interpolate the data from
survey years to generate information for remaining years. The second instrument is Industry
median Cash ETR. A firm’s engagement in tax avoidance is likely to be influenced by its peers
in that industry. Shleifer (2004) and Hasan et al. (2014) argue that peer pressure can force a firm
to adopt industry practices including tax avoidance behavior. Paying lower taxes than the rest
of the industry may attract unnecessary attention to the firm, while paying higher taxes relative
to industry peers may result in the loss of shareholder value. Firms may also compete in their
industry for specific tax benefits offered by the federal government to their industries. In fact, the
federal government regularly grants tax breaks and tax subsidies to firms within certain industries
resulting in low ETRs in those industries (Gardner, McIntyre, and Phillips, 2017). Therefore, the
average tax rate within a firm’s industry may serve as an important benchmark in determining
the ETR of a firm as it captures industry peer pressure and industry tax avoidance practices.
Based on the three-digit industry SIC code of a firm, we use the industry median tax rate as the
second instrument for Cash ETR. The exclusion restrictions for the instrumental variables are also
met as it is difficult to imagine a scenario in which the level of religiosity within a headquarter
county would directly affect a firm’s financial constraints. Similarly, the industry median tax
rate is unlikely to determine the financial constraints a firm may face. Therefore, any impact
these two instruments may have on financial constraints is expected to be indirectly through tax
avoidance. Both of these instrumental variables, Religiosity and Industry median Cash ETR, have
been previously used by Hasan et al. (2014) as instrumental variables for tax avoidance, and we
follow their study.
For Shelter, we employ another instrumental variable, Social Capital, calculated as the level
of civic norms and strength of social networks within the firm’s headquarter county. Hasan et al.
(2017) document that firms headquartered in counties with higher level of social capital engage
in significantly lower levels of tax avoidance and sheltering. Therefore, we conjecture that Social
Capital is a good candidate for an instrumental variable for tax sheltering, as they are strongly
negatively correlated. Additionally, the level of social capital associated with a county should
not directly affect the financial constraints of a firm whose headquarter is located in that county.
Therefore, Social Capital is correlated with tax sheltering, satisfying the validity assumption, and
it is uncorrelated with financial constraints, satisfying the exclusion restriction. We obtain the
data needed for the construction of this variable from the Northeast Regional Center for Rural
Development (NRCRD) at Pennsylvania State University and match it with firms’ headquarter
counties using postal zip code information.11
Using these sets of instrumental variables, we first run Equation (2) for Cash ETR and Shelter
separately. The fitted values of the tax avoidance variables obtained from this equation are then
used as key explanatory variables in the second stage for the dependent variable (the measure of
financial constraints) WWscore as follows:
WWscorei,t = δ0 + δ1 Fitted Tax Avoidance i,t + δ2 Return on Assetsi,t + δ3 Cash holdingsi,t
+ δ4 Market to Booki,t + δ5 Net Working Capitali,t + δ6 Capital Expendituresi,t
+ δ7 Inefficiencyi,t + δ8 Discretionary Accrualsi,t . (3)
II. Empirical Results
A. Summary Statistics and Univariate Test Results

We report the summary statistics of all variables in Table I. The mean Cash ETR in our sample
is about 26%, which is much lower than the statutory federal tax rate of 35%. In dollar terms,
reducing tax liability by 1% of pretax income of an average firm can result in savings of about
$3.2 million per year (mean pretax income in our sample is about $320 million). For most
profitable firms, tax savings from a similar reduction in the tax rate may amount as high as $280
million during a year. Thus, saving cash taxes by a few percentage points can have a significant
positive impact on a firm’s financial flexibility. The standard deviation of Cash ETR is about
13%, indicating that some firms avoid cash taxes significantly more than others.
We compare the mean values of our tax avoidance measures across strong governance and
poor governance firms and report the results in Table II. Based on three out of four governance
variables—namely, Institutional Ownership, Board Independence, and Delta—we find that firms
with strong governance avoid cash taxes to a greater extent than firms with poor governance:
on average, strong governance firms have about 0.9 to 2.7 percentage points lower Cash ETR
than poor governance firms. The univariate results for tax sheltering variables across strong
and poor governance groups are mixed. Based on the E-Index, strong governance firms have
significantly lower mean Shelter, whereas based on Institutional Ownership, Board Independence,
and Delta, strong governance firms have significantly greater mean Shelter scores. These results
are consistent with prior studies (Bird and Karolyi, 2017; Khan et al., 2017) that find that firms
with stronger governance, especially those with higher institutional ownership, take advantage of
tax shelters to improve their financial performance.
B. The Impact of Tax Avoidance on Financial Constraints

In this section, we present the results for the impact of corporate tax avoidance on a firm’s
financial constraints using a multivariate analysis. First, we focus on the effect of tax management
11
Social Capital is the first principal component from a principal component analysis on four variables: percentage of
voters who voted in presidential elections, response rate to the latest census, number of tax-exempt nonprofit organizations
per 10,000 residents, and number of social organizations per 100,000 residents. Data from NRCRD are available for years
1990, 1997, 2005, and 2014. We backfill the missing years using the previous years in which data are available, following
Hasan et al. (2017).
Table I. Summary Statistics
This table provides summary statistics for tax avoidance and financial constraints measures, as well as for all
control variables in the data set and covers the period of 1990–2015. WWscore captures financial constraints
developed by Whited and Wu (2006), where higher values represent tighter financial constraints. Cash
ETR is the long-run cash effective tax rate, calculated as five-year-centered moving sum of cash paid for
income taxes over five years scaled by the sum of pretax income (net of special items) over the same period.
Shelter is a dummy variable equal to one if a firm’s estimated shelter probability (estimated propensity of
using tax shelters following Wilson [2009]) belongs to the top quartile, and zero otherwise. Religiosity is
the fraction of population in the firm’s headquarter county that have an affiliation with organized religion.
Social Capital captures the level of civic norms and social networks within the firm’s headquarter county,
following Hasan et al. (2017). Return on Assets is the ratio of firm’s pretax income to total assets. Cash
Holdings is the balance of cash scaled by total assets. Market to Book ratio is the ratio of market value
of equity to the book value of equity. Net Working Capital is the net working capital (less cash) scaled by
total assets. Capital Expenditures is the ratio of capital expenditures scaled by total assets. Inefficiency is
calculated as the interaction between capital expenditures scaled by total assets and a dummy variable that is
one if a firm’s Tobin’s Q is lower than the industry’s median, zero otherwise. Discretionary Accruals is the
absolute value of discretionary accruals following Jones (1991). Bid-ask Spread is based on the firm’s stock
price as a measure of information asymmetry. Zscore is the alternative measure of financial constraints
based on Altman (1968). The following four variables capture governance mechanisms: E-Index is the
managerial entrenchment index following Bebchuk et al. (2009); Institutional Ownership is the fraction
of a firm’s common equity owned by institutional investors and is a measure of external monitoring by
institutional investors; Board Independence is the fraction of independent board members in a firm’s board
of directors; Delta is a measure of incentive-based compensation and a proxy for the alignment of the
interests of managers and shareholders.
N Mean SD Min Max

WWscore 35,241 –0.2816 0.1010 –0.5533 –0.0489
Cash ETR 35,241 0.2588 0.1328 0.0000 0.9958
Shelter (1/0) 35,241 0.2125 0.4091 0.0000 1.0000
Religiosity 29,901 0.5369 0.1176 0.0000 1.0000
Social Capital 35,054 –0.8940 1.2244 –8.0416 4.3062
Return on Assets 35,241 0.1004 0.0681 0.0022 0.3954
Cash Holdings 35,241 0.0948 0.1043 0.0000 0.6168
Market to Book 35,241 2.5657 2.0574 –0.9313 17.1293
Net Working Capital 35,241 0.1728 0.1732 –0.2455 0.6618
Capital Expenditures 35,241 0.0599 0.0536 0.0011 0.3679
Inefficiency 35,241 0.0365 0.0482 0.0000 0.2997
Discretionary Accruals 35,241 0.0791 0.1078 0.0006 1.2089
Bid-ask Spread 33,853 0.0218 0.0339 –0.0039 1.1478
Zscore 35,241 4.9551 3.8263 0.2732 32.6085
E-Index 9,395 2.7277 1.3871 0.0000 6.0000
Institutional Ownership 29,265 537.33 311.77 0.00 4235.73
Board Independence 11,105 0.7045 0.1660 0.0769 1.0000
Delta 15,846 898.84 6,546.40 0.01 388,945.70
captured by Cash ETR on financial constraints. We report our findings in Table III. In the first-
stage (Column (1)), we find that both instrumental variables, Religiosity and Industry median Cash
ETR, are positively and significantly associated with the endogenous variable Cash ETR. These
relationships are consistent with our earlier arguments on the validity of our chosen instruments.
First, firms headquartered in more religious counties are less likely to manage taxes consistent
with findings in the extant literature (Boone et al., 2013; Hasan et al., 2014). Second, a firm’s
Table II. Tax Avoidance and Governance
This table provides univariate comparisons for tax avoidance measures for firms with poor governance and
strong governance using four different governance measures. All variables are described in Table I. The
t-statistics are provided in brackets for these differences.
Governance Measure E-Index Institutional Ownership
Poor Strong Poor – Strong Poor Strong Poor – Strong

Cash ETR 0.252 0.256 –0.005∗∗ (–2.091) 0.274 0.247 0.027∗∗∗ (17.653)
N 5,169 4,226 15,742 13,523
Shelter 0.385 0.348 0.037∗∗∗ (3.686) 0.097 0.311 –0.214∗∗∗ (–46.169)
N 5,169 4,226 15,742 13,523
Governance Measure Board Independence Delta
Poor Strong Poor – Strong Poor Strong Poor – Strong

Cash ETR 0.255 0.241 0.014∗∗∗ (6.431) 0.257 0.248 0.009∗∗∗ (5.138)
N 6,262 4,843 8,001 7,845
Shelter 0.340 0.421 –0.082∗∗∗ (–8.846) 0.245 0.481 –0.235∗∗∗ (–31.787)
N 6,262 4,843 8,001 7,845
∗∗∗
Significant at the 0.01 level.
∗∗
involvement in tax management is positively associated with tax management practices of its
industry peers. This is consistent with our conjecture that a firm is more likely to engage in tax
management if its industry peers are also engaged in such activities to lower their tax liabilities,
possibly in an attempt to avoid being an outlier in its industry (Hasan et al., 2014).
We conduct several tests to check the relevance of our instruments. Specifically, we report
partial R2 , F-statistics for excluded instruments, and Cragg-Donald Wald test statistic for weak
instruments. Both of our instruments, Religiosity and Industry median Cash ETR, pass these tests
successfully. We also conduct Granger causality tests to confirm the endogenous relation between
tax avoidance variables and financial constraints index.
We present the second stage of the 2SLS estimation results for the full sample in Table
III, Column (2). Our results indicate that Cash ETR has a significantly negative relation with
WWscore. This means that the lower the amount of cash taxes paid by a firm as a percentage of its
taxable income, the greater the extent of its financial constraints. In other words, greater levels of
tax management may in fact increase firms’ financial constraints on average. For example, a one
standard deviation (13.28%) decrease in Cash ETR (higher avoidance) is associated with a 1.93%
increase in WWscore (greater constraints) at the absolute value of sample mean (an increase
of 0.0054 in WWscore). This finding is consistent with the claim that, on average, outside
investors may associate greater corporate tax avoidance with managerial incentive problems
(e.g., diversion of tax savings, earnings manipulation, hoarding bad news) and also view it
as a too-risky managerial strategy with potentially negative future consequences for firms. In
other words, the indirect costs of tax avoidance can outweigh the potential benefits of tax
savings that accrue to shareholders and therefore lead to an increase in financial constraints on
average.
The marginal impact of corporate tax avoidance on a firm’s financial constraints may differ
depending on the level of a firm’s existing level of financial constraints. Therefore, we consider it
Table III. The Impact of Tax Management on Financial Constraints
This table reports the impact of firms’ tax management, captured by Cash ETR, on their financial constraints
using 2SLS and instrumental variables. Instrumental variables for Cash ETR are Religiosity and Industry
median Cash ETR. Specification (1) reports the results of the first-stage regressions as well as several
instrument validity tests, including partial R-squared, F-statistics for excluded instruments, Cragg-Donald
Wald test statistic for weak instruments, and Granger causality test results between Cash ETR and WWscore.
Specifications (2–4) report second-stage results for all sample firms as well as for partitions of the sample
according to the financial constraints of firms. Constrained and unconstrained firms are based on the median
value of WWscore. R-squared values for all second-stage regressions in this and all consequent tables are
not reported, as they do not convey useful statistical information for 2SLS and are sometimes negative or
missing. All variables are described in Table I. The t-statistics are provided in parentheses. Chow test statistic
shows the significance of the difference between the coefficient of Cash ETR across constrained firms and
unconstrained firms.
Dependent Variable Cash ETR WWscore WWscore WWscore
Sample All All Constrained Unconstrained
(1) (2) (3) (4)
Cash ETR –0.041∗∗ –0.065∗∗∗ 0.010
(–2.016) (–3.998) (0.481)
Return on Assets 0.375∗∗∗ –0.107∗∗∗ –0.043∗∗∗ –0.077∗∗∗
(28.209) (–8.604) (–4.479) (–6.207)
Cash Holdings –0.081∗∗∗ 0.197∗∗∗ 0.029∗∗∗ 0.128∗∗∗
(–10.333) (37.554) (7.324) (19.737)
Market to Book –0.009∗∗∗ –0.006∗∗∗ –0.002∗∗∗ –0.002∗∗∗
(–17.977) (–14.749) (–4.864) (–6.095)
Net Working Capital 0.036∗∗∗ 0.210∗∗∗ 0.045∗∗∗ 0.139∗∗∗
(7.407) (61.249) (16.670) (36.509)
Capital Expenditures –0.131∗∗∗ 0.133∗∗∗ –0.056∗∗∗ 0.138∗∗∗
(–7.916) (10.134) (–5.536) (11.081)
Inefficiency 0.050∗∗∗ 0.152∗∗∗ 0.082∗∗∗ 0.026∗
(2.588) (10.985) (7.472) (1.901)
Discretionary Accruals –0.025∗∗∗ 0.102∗∗∗ 0.057∗∗∗ 0.010∗
(–3.439) (18.216) (14.074) (1.847)
Religiosity 0.061∗∗∗
(9.406)
Industry median Cash ETR 0.562∗∗∗
(31.663)
Constant 0.085∗∗∗ –0.314∗∗∗ –0.196∗∗∗ –0.394∗∗∗
(12.632) (–56.619) (–45.130) (–72.067)
N 29,901 29,901 17,526 12,375
R2 0.091
Partial R2 0.038
F-statistic for excluded instruments 547.540∗∗∗
Cragg-Donald Wald test, F-statistic 589.800∗∗∗
WWscore Granger causes Cash ETR, χ 2 53.440∗∗∗
Cash ETR Granger causes WWscore, χ 2 32.191∗∗∗
Chow test statistic 6,260.643∗∗∗
∗∗∗
∗∗
∗
important to examine this relation conditional on the initial level of these constraints. We divide
the full sample into constrained and unconstrained groups based on the median value of WWscore
and run the 2SLS regression model for the impact of tax avoidance on financial constraints in
each of these groups separately. The second-stage results of these regressions for constrained
(above median value of WWscore) and unconstrained (below median value) groups are reported
in Table III, Columns (3) and (4), respectively. We report Chow test statistics to determine
whether the coefficient estimates of the tax avoidance variables are significantly different across
the constrained group and the unconstrained group.12 Test statistics confirm that the coefficients
are significantly different. We find that the negative relationship documented at the full sample
level is mainly driven by the group of firms that are financially constrained. For constrained
firms, higher level of tax management has a much stronger negative impact on their financial
constraints. More specifically, we document that a one standard deviation increase in Cash ETR
is associated with a 3.07% decrease in WWscore in the constrained subsample. The statistical
significance of this relation is also larger in this subsample in comparison to the full sample. In
contrast, for the unconstrained group, we find no significant relation between tax avoidance and
financial constraints. In other words, conditional on being financially unconstrained initially, tax
management by a firm does not affect its financial constraints. When a firm is more constrained
initially, however, our results suggest that engaging in tax avoidance (lowering ETRs) will further
exacerbate the firm’s financial constraints.
We next turn to analyzing the impact of firms’ tax sheltering activities on financial constraints.
Tax management and tax sheltering may affect a firm’s financial constraints differently as they
capture different levels of aggressiveness in tax planning. Table IV reports the results of both
stages of 2SLS estimation for the impact of tax sheltering on financial constraints. In Column
(1), we document the validity of the instrumental variable Social Capital, as it has a strong
negative relation with our tax sheltering variable. Firms in localities with high social capital are
less likely to engage in tax sheltering activities. In the second-stage regressions presented in
subsequent Columns (2)–(4), we show that tax sheltering increases a firm’s financial constraints
on average, but this result is mainly driven by the subsample of firms that were already constrained
initially. In contrast, in the subsample of financially unconstrained firms, tax sheltering does not
have a significant effect on financial constraints. Overall, our findings presented in Tables III
and IV suggest that the effect of tax sheltering on financial constraints is similar to that of tax
management. Both tax management and tax sheltering increase the degree of financial constraints
in firms that are already constrained.
These results are consistent with the notion that outside investors associate corporate tax avoid-
ance with opaque information environments in which managerial moral hazard (e.g., diversion,
earnings management) and the risk of adverse selection for investors due to information asym-
metry are greater (Lev and Nissim, 2004; Hanlon, 2005; Desai and Dharmapala, 2006, 2009).
In such information environments, corporate tax avoidance may increase the uncertainty about
the valuations of firms with more aggressive tax sheltering practices, exposing them to higher
price crash risks (Kim et al., 2011). To improve our understanding of the relation between tax
avoidance and financial constraints, we next examine whether our findings regarding the impact
of tax avoidance on financial constraints can be differentiated conditional on the strength of a
firm’s corporate governance.
12
The following URL provides details of the calculation of the Chow test statistic in Stata: https://www.stata.com/support/
faqs/statistics/computing-chow-statistic/. Because Stata does not have an official command to perform the Chow test in
2SLS model, we manually calculate the Chow statistic.
Table IV. The Impact of Tax Sheltering on Financial Constraints
This table reports the impact of firms’ tax sheltering, captured by Shelter, on their financial constraints using
2SLS and instrumental variables. Instrumental variables for Shelter are Social Capital. Specification (1)
reports the results of the first-stage regressions as well as several instrument validity tests, including partial
R-squared, F-statistics for excluded instruments, Cragg-Donald Wald test statistic for weak instruments,
and Granger causality test results between Shelter and WWscore. Specifications (2–4) report second-stage
results for all sample firms as well as for partitions of the sample according to the financial constraints
of firms. Constrained and unconstrained firms are based on the median value of WWscore. R-squared
values for all second-stage regressions in this and all consequent tables are not reported, as they do not
convey useful statistical information for 2SLS and are sometimes negative or missing. All variables are
described in Table I. The t-statistics are provided in parentheses. Chow test statistic shows the significance
of the difference between the coefficient of Shelter across poor governance and strong governance for the
respective governance variable.
Dependent Variable Shelter WWscore WWscore WWscore

Sample All All Constrained Unconstrained
(1) (2) (3) (4)
Shelter 0.225∗∗∗ 0.173∗∗∗ –0.008
(6.445) (4.336) (–1.191)
Return on Assets 0.755∗∗∗ –0.287∗∗∗ –0.126∗∗∗ –0.072∗∗∗
(19.976) (–9.479) (–7.322) (–6.545)
Cash Holdings –0.326∗∗∗ 0.262∗∗∗ 0.013∗∗ 0.113∗∗∗
(–17.047) (19.618) (2.240) (22.479)
Market to Book 0.025∗∗∗ –0.011∗∗∗ –0.003∗∗∗ –0.002∗∗∗
(17.996) (–10.757) (–5.565) (–5.821)
Net Working Capital –0.465∗∗∗ 0.321∗∗∗ 0.038∗∗∗ 0.137∗∗∗
(–37.422) (19.382) (11.836) (30.270)
Capital Expenditures –0.695∗∗∗ 0.312∗∗∗ –0.038∗∗∗ 0.140∗∗∗
(–13.301) (10.272) (–2.956) (11.238)
Inefficiency 0.013 0.143∗∗∗ 0.048∗∗∗ 0.020
(0.214) (6.280) (3.028) (1.634)
Discretionary Accruals –0.038∗ 0.112∗∗∗ 0.048∗∗∗ 0.008
(–1.894) (12.581) (8.373) (1.595)
Social Capital –0.201∗∗∗
(–11.331)
Constant 0.209∗∗∗ –0.385∗∗∗ –0.208∗∗∗ –0.391∗∗∗
(32.320) (–47.596) (–92.991) (–144.324)
N 35,054 35,054 19,053 16,001
R2 0.080
Partial R2 0.004
F-statistic for excluded instruments 128.380∗∗∗
Cragg-Donald Wald test, F-statistic 135.880∗∗∗
WWscore Granger causes Shelter, χ 2 15.142∗∗∗
Shelter Granger causes WWscore, χ 2 10.549∗∗∗
Chow test statistic 21,871.790∗∗∗
∗∗∗
∗∗
∗
C. The Role of Governance in the Effect of Tax Avoidance
on Financial Constraints
We begin our analysis of the role of corporate governance by dividing our full sample into
strong governance and poor governance groups based on the median values of the respective
governance variable.13 Then, we examine the impact of tax avoidance on financial constraints
separately for each governance group. Similar to our results for constraints groups, we use the
Chow test to determine the significance of the difference between tax avoidance variables across
poor governance and strong governance groups. Table V, Panel A, reports the results of the
effect of tax management on financial constraints. We find that within the group of firms with
poor governance, the impact of Cash ETR on WWscore is negative, suggesting that for these
firms, tax avoidance results in greater financial constraints. For example, we find that a one
conditional standard deviation increase (24.99%) in Cash ETR (lower avoidance) is associated
with a 15.70% decrease in WWscore (lower constraints) at the absolute value of conditional sample
mean (a decrease of 0.0462 in WWscore) when Delta is used as the measure of governance. For
the group of firms with strong governance, the direction of the relation is mixed with low
statistical significance. Within the high Institutional Ownership and low E-Index groups, we
document a negative relation between tax management and financial constraints, whereas within
the high Delta group the relation is positive and barely significant. Finally, within the high
Board Independence governance group, we find no statistically significant relation between tax
avoidance and financial constraints.
In Table V, Panel B, we examine the role of governance in the relation between tax sheltering and
financial constraints. We find that conditional on poor governance, the impact of tax sheltering
on WWscore is significantly positive, which suggests that tax sheltering leads to greater financial
constraints especially in poorly governed firms. In other words, if a poorly governed firm engages
in tax sheltering, it is likely to suffer greater financial constraints. These results are also consistent
with Bird and Karolyi (2017), who find that firms with poor governance mechanisms are less
likely to engage in tax sheltering through international tax havens. In the subsample of firms with
strong governance, we find that the impact of Shelter on WWscore is mixed and depends on the
particular governance measure used. While the coefficient of Shelter is positive within the high
Institutional Ownership, high Delta, and low E-Index groups (weakly significant), it is negative
and significant within the high Board Independence group.
Overall, our findings in this section indicate that the quality of a firm’s corporate governance
significantly affects the impact of tax avoidance on financial constraints. In firms with poor
governance mechanisms, avoiding taxes is associated with greater financial constraints. In addi-
tion to complementing agency problems such as diversion, tax avoidance by a poorly governed
firm may also be perceived as a highly risky managerial investment strategy, which may further
deteriorate a firm’s financial constraints. Rego and Wilson (2012) and Armstrong et al. (2015)
find that CEOs’ risk-taking equity incentives exhibit a positive relation with the average level of
tax avoidance. They argue that tax avoidance should be characterized as one of many alternative
risky investment opportunities available to CEOs. In contrast, avoiding taxes may not necessarily
hurt firms with stronger governance mechanisms, suggesting that these firms may be likely to
engage in tax avoidance to achieve greater financial flexibility. We also examine whether these
mixed results can be attributed to the initial level of a firm’s financial constraints. We separate
the sample based on the levels of governance and financial constraints. We find (untabulated)
13
Our results are similar when we use the top and bottom quartiles of each governance measure to divide the sample into
strong governance and poor governance groups.
Table V. The Impact of Governance on the Relation between Tax Avoidance and Financial Constraints
This table reports the results of 2SLS regression analyzing the relation between tax management (Panel A) and tax sheltering (Panel B) and financial constraints
for poor governance firms and strong governance firms using the median values of four different governance measures. All variables are described in Table I.
The t-statistics are provided in parentheses. Chow test statistic shows the significance of the difference between the coefficient of Cash ETR (Shelter) across
poor governance and strong governance for the respective governance variable.
Governance Sample Poor Strong
Governance Variable Inst. Ownership Delta E-Index Board Indep. Inst. Ownership Delta E-Index Board Indep.
(1) (2) (3) (4) (5) (6) (7) (8)
Panel A. Tax Management
Cash ETR –0.172∗∗∗ –0.185∗∗∗ –0.181∗∗∗ –0.168∗∗∗ –0.073∗∗∗ 0.063∗ –0.093∗ –0.029
(–5.018) (–4.946) (–3.179) (–3.970) (–2.731) (1.681) (–1.944) (–0.432)
Return on Assets –0.066∗∗∗ 0.039 –0.067∗ –0.009 –0.046∗∗∗ –0.098∗∗∗ –0.083∗∗∗ –0.113∗∗∗
(–3.550) (1.634) (–1.906) (–0.332) (–2.631) (–3.922) (–2.627) (–2.992)
Cash Holdings 0.158∗∗∗ 0.185∗∗∗ 0.173∗∗∗ 0.167∗∗∗ 0.205∗∗∗ 0.231∗∗∗ 0.182∗∗∗ 0.215∗∗∗
(21.553) (16.647) (10.560) (13.487) (26.708) (21.046) (12.503) (13.247)
Market to Book –0.007∗∗∗ 0.001 –0.002∗∗ –0.004∗∗∗ –0.002∗∗∗ 0.001∗∗ –0.003∗∗∗ –0.000
(–9.689) (1.337) (–2.021) (–6.732) (–4.659) (2.443) (–3.221) (–0.355)
Net Working Capital 0.153∗∗∗ 0.167∗∗∗ 0.185∗∗∗ 0.160∗∗∗ 0.195∗∗∗ 0.212∗∗∗ 0.191∗∗∗ 0.211∗∗∗
(30.540) (29.376) (21.289) (23.943) (43.224) (33.737) (21.463) (21.646)
Capital Expenditures –0.032 0.163∗∗∗ 0.155∗∗∗ 0.103∗∗∗ 0.187∗∗∗ 0.298∗∗∗ 0.153∗∗∗ 0.198∗∗∗
(–1.551) (6.839) (4.656) (3.801) (10.176) (12.926) (4.234) (4.698)
Inefficiency 0.138∗∗∗ 0.065∗∗∗ 0.009 0.068∗∗∗ 0.087∗∗∗ 0.016 0.111∗∗∗ 0.030
(6.383) (2.859) (0.287) (2.678) (4.542) (0.620) (2.812) (0.687)
Discretionary Accruals 0.082∗∗∗ 0.032∗∗∗ 0.022∗ 0.020∗∗ 0.031∗∗∗ 0.036∗∗∗ 0.016 0.020
(11.395) (3.948) (1.695) (2.094) (4.328) (3.262) (1.201) (1.457)
Constant –0.216∗∗∗ –0.328∗∗∗ –0.345∗∗∗ –0.330∗∗∗ –0.358∗∗∗ –0.439∗∗∗ –0.359∗∗∗ –0.405∗∗∗
(–22.555) (–32.866) (–23.073) (–29.081) (–50.178) (–44.164) (–26.866) (–22.673)
N 12,358 6,314 3,520 5,266 11,779 6,167 2,956 2,889
Bayar, Huseynov, & Sardarli r Corporate Governance, Tax Avoidance, and Financial Constraints
Chow test statistic 1,806.877∗∗∗ 4,673.849∗∗∗ 5,355.411∗∗∗ 5,296.907∗∗∗
(Continued)
665
666
Table V. The Impact of Governance on the Relation between Tax Avoidance and Financial Constraints (Continued)
Governance Sample Poor Strong
(1) (2) (3) (4) (5) (6) (7) (8)
Panel B. Tax Sheltering
Shelter 0.073 0.050∗∗∗ 0.100∗∗∗ 0.126∗∗∗ 0.047∗∗∗ 0.087∗∗ 0.044∗ –0.038∗∗

(1.539) (3.292) (3.482) (2.724) (3.194) (2.521) (1.791) (–2.196)
Return on Assets –0.176∗∗∗ –0.081∗∗∗ –0.239∗∗∗ –0.196∗∗∗ –0.134∗∗∗ –0.134∗∗∗ –0.171∗∗∗ –0.070∗∗
(–5.657) (–4.110) (–5.883) (–4.963) (–7.076) (–4.043) (–4.717) (–2.482)
Cash Holdings 0.178∗∗∗ 0.223∗∗∗ 0.259∗∗∗ 0.222∗∗∗ 0.224∗∗∗ 0.245∗∗∗ 0.194∗∗∗ 0.202∗∗∗
(14.439) (22.197) (13.228) (12.625) (27.075) (15.348) (14.079) (15.388)
Market to Book –0.007∗∗∗ 0.001∗∗ –0.003∗∗∗ –0.006∗∗∗ –0.002∗∗∗ –0.000 –0.002∗∗ –0.000
(–4.863) (2.328) (–2.818) (–3.771) (–4.559) (–0.103) (–2.308) (–0.493)
Net Working Capital 0.170∗∗∗ 0.178∗∗∗ 0.244∗∗∗ 0.211∗∗∗ 0.222∗∗∗ 0.259∗∗∗ 0.215∗∗∗ 0.171∗∗∗
(13.217) (23.046) (12.108) (10.107) (25.727) (12.531) (14.812) (13.069)
Capital Expenditures 0.044 0.248∗∗∗ 0.319∗∗∗ 0.267∗∗∗ 0.256∗∗∗ 0.417∗∗∗ 0.188∗∗∗ 0.163∗∗∗
(1.616) (10.146) (7.504) (5.369) (12.224) (7.566) (4.793) (5.126)
Inefficiency 0.116∗∗∗ 0.045∗ –0.044 –0.005 0.058∗∗∗ –0.058 0.072∗ 0.009
(4.837) (1.800) (–1.076) (–0.102) (2.880) (–1.589) (1.772) (0.269)
Discretionary Accruals 0.093∗∗∗ 0.028∗∗ –0.001 –0.010 0.025∗∗∗ 0.017 0.001 0.021∗∗
(12.203) (3.073) (–0.082) (–0.557) (3.004) (1.211) (0.045) (2.084)
Constant –0.273∗∗∗ –0.394∗∗∗ –0.438∗∗∗ –0.412∗∗∗ –0.399∗∗∗ –0.472∗∗∗ –0.404∗∗∗ –0.400∗∗∗
(–63.951) (–84.650) (–38.005) (–30.510) (–80.782) (–26.171) (–49.910) (–52.160)
N 13,428 7,970 5,157 6,241 15,689 7,804 4,212 4,833
Chow test statistic 9,242.490∗∗∗ 11,251.384∗∗∗ 11,401.821∗∗∗ 11,919.246∗∗∗
∗∗∗
∗∗
∗
Financial Management r Fall 2018
weak evidence that tax management in constrained firms with poor governance may further ex-
acerbate their financial conditions, whereas tax management in unconstrained firms with strong
governance may provide some additional financial flexibility.
III. Supplemental Analysis

In this section, we present the results of additional tests to check the robustness of our main
results. More specifically, we introduce an alternative measure for financial constraints and
analyze the potential effects of a firm’s information environment and earnings management on
the relation between tax avoidance and financial constraints.14
A. Alternative Measure of Financial Distress—Z-Score

In our empirical analysis presented above, we used the financial constraint index of Whited and
Wu (2006) as the measure of financial constraints. In this section, we examine whether our results
still hold when we use Altman’s (1968) Z-score as an alternative measure of financial constraints.
Zscore measure captures financial distress and the likelihood of bankruptcy in the near term.
Lower values of Zscore indicate greater financial distress and will be correlated with a greater
degree of financial constraints. Constrained firms may engage in tax avoidance to increase their
Zscore and avoid potential financial distress.
Similar to our above analysis with WWscore as our measure of financial constraints, we first
divide our sample into firms with strong governance and firms with poor governance using the
median values of our governance variables and then into constrained firms and unconstrained
firms based on Zscore of a firm in a given year. We identify firm-year observations with a
Zscore below 3.00 as constrained firm-years and those with a Zscore equal to and above 3.00
as unconstrained firm-years. Then, we examine the impact of tax avoidance variables on Zscore
separately for each group.
We report our results for poorly governed firms conditional on financial constraints in Table
VI. For brevity, we report only the coefficients of tax avoidance variables although we control for
other variables mentioned above. In Panel A, we present our results for the effect of tax avoidance
on financial constraints within constrained firms with poor governance. We find that within
constrained firms (low Zscore firms) with poor governance, Cash ETR has a positive effect on
Zscore, whereas for most governance measures, tax sheltering has a negative impact on Zscore.
These results suggest that firms with greater tax management and tax sheltering activities are
likely to have greater financial constraints (lower Zscore). These findings are in line with those
for constrained firms with poor governance when we used WWscore as a measure of financial
constraints. In Panel B, we report our findings for unconstrained firms (high Zscore firms) with
poor governance. We find that the coefficient of Cash ETR is negative and significant within poor
governance groups, whereas Shelter has a negative coefficient in low Delta and high E-Index
firms. For other governance variables, the coefficients of Shelter are also negative, although not
significant at conventional levels. Thus, our evidence suggests that within unconstrained firms
14
We also conduct matching estimation to investigate the impact of tax management on financial constraints. We match
high-tax avoidance firms (treated observations with a below-median Cash ETR) with low-tax avoidance firms based
on their observable firm characteristics. We conduct treatment effect estimation based on the propensity score and the
nearest-neighbor matching methods. Our untabulated results are similar to our findings from the 2SLS model and show
that poor governance firms and constrained firms with low Cash ETR (high tax avoidance) are likely to have greater
financial constraints.
668
Table VI. Poor Governance Firms and Alternative Definition of Financial Constraints
This table reports the results of 2SLS regression analyzing the impact of governance on the relation between tax avoidance and financial constraints using
Z-score as an alternative measure of financial constraints and four governance measures. Panel A reports results for poor governance (below the median values
of the corresponding governance measure) and financially constrained firms (low Z-score, <3), and Panel B reports results for poor governance and financially
unconstrained firms (high Z-score, ࣙ3). For brevity, only the coefficients for tax avoidance variables are reported while controlling for other variables in Equation
(2). All variables are described in Table I. The t-statistics are provided in parentheses. Chow test statistic shows the significance of the difference between the
coefficient of Cash ETR (Shelter) across poor governance and low Z-score group and poor governance and high Z-score group.
Tax Avoidance Variable Cash ETR Shelter
(1) (2) (3) (4) (5) (6) (7) (8)
Panel A. Poor Governance and Low Z-Score
Tax Avoidance 7.491∗∗∗ 7.350∗∗∗ 13.710∗∗ 11.268∗∗∗ 0.165 –0.181 –0.553∗∗∗ –1.311∗∗∗
(6.416) (3.291) (2.087) (2.721) (0.590) (–1.409) (–2.713) (–2.708)
N 3,662 2,132 1,195 1,545 3,949 2,699 1,662 1,781
Chow test statistic 11,511.344∗∗∗ 5,883.377∗∗∗ 2,808.336∗∗∗ 4,632.705∗∗∗ 13,566.937∗∗∗ 7,156.948∗∗∗ 4,840.786∗∗∗ 5,792.352∗∗∗
Panel B. Poor Governance and High Z-Score
Tax Avoidance –0.566 –3.840∗∗∗ –6.197∗∗∗ –7.919∗∗∗ –0.866 –2.990∗∗∗ –1.887∗ –2.630
(–0.416) (–2.771) (–3.184) (–3.854) (–0.452) (–4.29) (–1.726) (–1.159)
N 8,696 4,182 2,325 3,721 9,479 5,271 3,495 4,460
∗∗∗
∗∗
∗
with poor governance, tax management may have a positive effect on Zscore, indicating that
unconstrained firms (with a high Zscore) with poor governance can further benefit from lowering
their Cash ETR. However, tax sheltering still has a negative effect on Zscore in these firms, which
suggests that engaging in tax sheltering activities may increase their financial constraints.
Next, we present our results for firms with strong governance conditional on financial con-
straints (Zscore) in Table VII. In Panel A, our findings indicate that within constrained firms (low
Zscore firms) with high Institutional Ownership, high Delta, and low E-Index, Cash ETR has
a positive impact on Zscore, which suggests that tax management activities may lead to greater
financial constraints (a lower Zscore). We also find that the coefficient of Shelter is negative for
all poor governance groups but significant only for the groups of firms with low Institutional
Ownership and high Delta. In Panel B, we find that within unconstrained firms (high Zscore
firms) with strong governance, Cash ETR has a negative and significant impact on Zscore in all
specifications. This suggests that tax management further reduces financial distress and financial
constraints in unconstrained firms with strong governance. Our results for tax sheltering show that
Shelter has a negative and significant coefficient for three of the four strong governance groups.
This result indicates that even for unconstrained firms with strong governance, tax sheltering may
result in greater financial constraints.
Overall, our results for Altman’s Z-score as an alternative measure of financial constraints
indicate that when firms are constrained, both tax management and tax sheltering activities in-
crease the risk of financial distress, and therefore, they can further exacerbate firms’ financial
constraints. However, unconstrained firms (high Zscore firms) might benefit from tax manage-
ment by further reducing their risk of financial distress (a greater Zscore), and this effect is more
pronounced in firms with strong governance.
B. The Role of Information Asymmetry (Transparency of the Information

Environment)
Earlier, we noted that when tax avoidance complements an opaque information environment,
the costs of tax avoidance can outweigh the potential benefits of tax savings that accrue to
shareholders and therefore lead to an increase in financial constraints. Here, we examine whether
tax avoidance affects a firm’s financial constraints differently conditional on the opaqueness of
the market environment that it provides to its investors. We use the average daily bid-ask spread
of a firm’s stock price (calculated from the Center for Research in Security Prices [CRSP]) as a
measure of information asymmetry assuming that firms with greater information asymmetry will
also have greater bid-ask spreads. First, we divide our sample into poor and strong governance
groups as above. Next, we divide each governance group into high- and low-spread firms based
on the sample median value of Bid-ask Spread. We conduct a similar analysis of tax avoidance on
financial constraints separately for each group. Results reported in Tables VIII and IX indicate
that Cash ETR has a negative coefficient within poor governance and high-spread firms and
poor governance firms with low spreads, although the economic and statistical significance
within the latter is much weaker. Thus, when firms have poor governance, we find some strong
evidence that tax management may lead to greater financial constraints only in the presence
of greater information asymmetry between firms and market participants. We do not find a
significant difference across high- and low-spread firms with poor governance for the impact of
tax sheltering on financial constraints such that in both subgroups, tax sheltering relaxes financial
constraints in a limited number of specifications. We do not find meaningfully significant results
regarding information asymmetry within strong governance firms. This suggests that in firms
670
Table VII. Strong Governance Firms and Alternative Definition of Financial Constraints
This table reports the results of 2SLS regression analyzing the impact of governance on the relation between tax avoidance and financial constraints using
Z-score as an alternative measure of financial constraints and four governance measures. Panel A reports results for strong governance (above the median
value of the corresponding governance measure) and financially constrained firms (low Z-score, <3), and Panel B reports results for strong governance and
financially unconstrained firms (high Z-score, ࣙ3). For brevity, only the coefficients for tax avoidance variables are reported while controlling for other variables
in Equation (2). All variables are described in Table I. The t-statistics are provided in parentheses. Chow test statistic shows the significance of the difference
between the coefficient of Cash ETR (Shelter) across strong governance and low Z-score group and strong governance and high Z-score group.
(1) (2) (3) (4) (5) (6) (7) (8)
Panel A. Strong Governance and Low Z-Score
Tax Avoidance 4.776∗∗∗ 8.432∗∗∗ 0.974∗ 88.670 –0.453∗∗∗ –0.646∗∗ –0.176 –0.309
(6.876) (3.142) (1.787) (0.221) (–3.770) (–2.013) (–0.400) (–0.890)
N 3,449 1,651 879 966 4,689 2,131 1,251 1,569
Chow test statistic 11,215.065∗∗∗ 5,609.667∗∗∗ 2,855.578∗∗∗ 100.928∗∗∗ 13,985.506∗∗∗ 6,783.414∗∗∗ 4,171.029∗∗∗ 4,672.864∗∗∗
Panel B. Strong Governance and High Z-Score
Tax Avoidance –7.710∗∗∗ –9.230∗∗∗ –5.468∗∗ –5.098∗∗ –3.326∗∗∗ 2.373 –2.306∗∗ –1.816∗∗
(–6.562) (–5.392) (–2.425) (–2.382) (–4.174) (1.436) (–2.331) (–2.145)
N 8,330 4,516 2,077 1,923 11,000 5,673 2,961 3,264
∗∗∗
∗∗
∗
Table VIII. Poor Governance Firms and Information Environment
This table reports the results of 2SLS regression analyzing the impact of governance and information environment on the relation between tax avoidance and
financial constraints. Panel A reports results for poor governance (below the median value of the corresponding governance measure) and high Bid-ask Spread
(above sample median, hence, lower quality information environment); Panel B reports results for poor governance and low Bid-ask Spread. For brevity, only the
coefficients for tax avoidance variables are reported while controlling for other variables in Equation (2). All variables are described in Table I. The t-statistics
are provided in parentheses. Chow test statistic shows the significance of the difference between the coefficient of Cash ETR (Shelter) across poor governance
and high bid-ask spread group and poor governance and low bid-ask spread group.
(1) (2) (3) (4) (5) (6) (7) (8)
Panel A. Poor Governance and High Bid-ask Spread
Tax Avoidance –0.271∗∗∗ –0.287∗∗∗ –0.536∗∗∗ –0.572∗∗∗ –0.152∗∗∗ 0.047 0.045 0.251
(–7.633) (–3.646) (–3.000) (–2.673) (–4.255) (1.456) (0.842) (1.295)
N 10,259 2,966 1,060 1,874 10,620 2,972 1,059 1,880
Panel B. Poor Governance and Low Bid-ask Spread
Tax Avoidance –0.105 –0.186∗∗∗ –0.144∗∗ –0.131∗∗∗ –0.058∗ –0.035∗∗ 0.050 0.065
(–1.088) (–4.488) (–2.262) (–3.267) (–1.732) (–2.242) (1.617) (1.597)
N 2,099 3,348 2,460 3,392 2,808 4,998 4,098 4,361
∗∗∗
∗∗
∗
Bayar, Huseynov, & Sardarli r Corporate Governance, Tax Avoidance, and Financial Constraints
671
672
Table IX. Strong Governance Firms and Information Environment
This table reports the results of 2SLS regression analyzing the impact of governance and information environment on the relation between tax avoidance and
financial constraints. Panel A reports results for strong governance (above the median value of the corresponding governance measure) and high Bid-ask Spread
(above sample median, hence, lower quality information environment); Panel B reports results for poor governance and low Bid-ask Spread. For brevity, only the
coefficients for tax avoidance variables are reported while controlling for other variables in Equation (2). All variables are described in Table I. The t-statistics
are provided in parentheses. Chow test statistic shows the significance of the difference between the coefficient of Cash ETR (Shelter) across strong governance
and high bid-ask spread group and strong governance and low bid-ask spread group.
(1) (2) (3) (4) (5) (6) (7) (8)
Panel A. Strong Governance and High Bid-ask Spread
Tax Avoidance –0.211∗∗∗ –0.013 –0.561∗∗ –0.115 –0.021 0.317 0.041 –0.072∗∗
(–3.359) (–0.140) (–2.314) (–0.227) (–0.928) (0.826) (0.811) (–2.135)
N 3,989 1,637 1,067 489 4,044 1,638 1,072 489
Panel B. Strong Governance and Low Bid-ask Spread
Tax Avoidance –0.083∗∗∗ 0.010 –0.088∗ –0.045 –0.033∗ –0.008 –0.039∗ –0.037∗
(–2.839) (0.260) (–1.876) (–0.728) (–2.512) (–0.430) (–1.814) (–1.890)
N 7,790 4,530 1,889 2,400 11,645 6,166 3,140 4,344
∗∗∗
∗∗
∗
with strong governance, opaqueness of the information environment does not play an important
role in the relation between tax avoidance and financial constraints.
C. The Role of Earnings Management

Several studies suggest that managers can avoid taxes or use certain tax accounts (such as
valuation allowance, contingency reserve, and foreign tax benefits) not necessarily to increase
firm value by reducing taxes but to manipulate earnings as part of their broader earnings manage-
ment agenda (Hanlon and Heitzman, 2010). Firms may implement tax management activities to
reduce accrued tax expenses or decrease the valuation allowances when they are under the pres-
sure to meet or beat financial analyst forecasts (Dhaliwal, Gleason, and Mills, 2004; Frank and
Rego, 2006; Blouin et al., 2010). Regardless of these motivations, tax avoidance in conjunction
with earnings management is likely to worsen the firm’s information environment and deter its
potential investors (Kim et al., 2011; Hong et al., 2014). Since earnings management generally
increases the riskiness of cash flows and the firm’s opacity, it is also likely to increase the costs
associated with external financing. Following this literature, we examine whether our results are
affected by earnings management, especially in constrained firms with poor governance.
We use absolute discretionary accruals as a measure of earnings management following Yu
(2008) and Hong et al. (2014) and estimate discretionary accruals following the modified cross-
sectional Jones (1991) model, as described by Dechow, Sloan, and Sweeney (1995) and modified
by Kothari et al. (2005). First, we separate our full sample of firms into eight groups: strong
governance and poor governance, financially constrained and unconstrained, and high earnings
management and low earnings management groups (based on the median value of absolute dis-
cretionary accruals). We examine the impact of tax avoidance on financial constraints separately
in each group. In untabulated results, we find that the level of earnings management does not
affect our results reported in previous sections.
IV. Conclusion
While prior studies examined the relation between corporate tax avoidance and financial
constraints, none has investigated how corporate governance moderates this relation. We fill this
gap in the literature by examining whether the impact of corporate tax avoidance on financial
constraints depends on the quality of a firm’s governance mechanisms. In addition, we also
explore whether firms can relax their financial constraints through tax avoidance, especially
when they are financially constrained. Finally, we differentiate between fiscally responsible tax
management using cash ETRs and tax sheltering using indicator variables based on the firm’s
propensity to shelter taxes. Our main measure of financial constraints is WWscore, an index
developed by Whited and Wu (2006).
Our empirical results indicate that the impact of tax management on financial constraints varies
depending on the level of governance and financial constraints. We find that both tax management
and tax sheltering are associated with greater financial constraints in firms with poor governance
(based on all four governance variables: institutional ownership, board independence, incentive-
based compensation, and management entrenchment). In contrast, in firms with strong corporate
governance, the effect of tax management and tax sheltering on financial constraints is weaker
or insignificant. This result is consistent with the idea that strongly governed firms use tax
management effectively, which can also benefit them in the long run by not exacerbating their
financial constraints. We also find that tax management and tax sheltering are associated with
greater financial constraints in constrained firms. Overall, our findings indicate that constrained
firms (and their investors) stand to benefit from improving their governance practices to mitigate
the negative impacts of both tax management and tax sheltering.
Our study shows that in the presence of agency problems that create conflicts of interest
between managers and shareholders, the effect of tax avoidance on firms’ financial constraints
depends on the quality of the corporate governance mechanisms that discipline and incentivize
firm managers. Our results suggest that tax avoidance can help firms to relax their financial
constraints to a certain extent only if they have strong governance mechanisms in place.
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Corporate Governance, Tax Avoidance,

and Financial Constraints

I. Data, Variables, and Research Design

A. Financial Constraints, Tax Avoidance, and Governance Measures

WWscore = − 0.091CFit − 0.062 DIVPOSit + 0.021 LTDEBTit − 0.044 LNTAit

B. Determinants of Financial Constraints

C. 2SLS Method and Instruments

+ γ4 Market to Booki,t + γ5 Net Working Capitali,t + γ6 Capital Expendituresi,t

+ δ7 Inefficiencyi,t + δ8 Discretionary Accrualsi,t . (3)

II. Empirical Results

A. Summary Statistics and Univariate Test Results

B. The Impact of Tax Avoidance on Financial Constraints

N Mean SD Min Max

Governance Measure E-Index Institutional Ownership

Poor Strong Poor – Strong Poor Strong Poor – Strong

Poor Strong Poor – Strong Poor Strong Poor – Strong

Dependent Variable Shelter WWscore WWscore WWscore

Governance Sample Poor Strong

Chow test statistic 1,806.877∗∗∗ 4,673.849∗∗∗ 5,355.411∗∗∗ 5,296.907∗∗∗

Shelter 0.073 0.050∗∗∗ 0.100∗∗∗ 0.126∗∗∗ 0.047∗∗∗ 0.087∗∗ 0.044∗ –0.038∗∗

III. Supplemental Analysis

A. Alternative Measure of Financial Distress—Z-Score

Tax Avoidance Variable Cash ETR Shelter

B. The Role of Information Asymmetry (Transparency of the Information

Tax Avoidance Variable Cash ETR Shelter

Tax Avoidance Variable Cash ETR Shelter

Table IX. Strong Governance Firms and Information Environment

Tax Avoidance Variable Cash ETR Shelter

C. The Role of Earnings Management

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