Tax Avoidance and Tunneling: Empirical Analysis from an Agency Perspective

What is it about?

Taking advantage of the agency conflicts between controlling shareholders and minority shareholders and the weak corporate governance in a transition economy, we investigate the relationship between tax avoidance (proxied by effective tax rates) and tunneling (proxied by related-party lending) from a principal-principal agency perspective. We find that corporate tax avoidance is positively associated with tunneling after controlling for firm characteristics, corporate governance, and institutional factors that affect tunneling. This relationship is more pronounced for firms with cash shortages and in periods with relatively weak investor protection. In addition, the value-enhancing implications of tax avoidance are reduced for firms in which tax avoidance is highly correlated with tunneling. By demonstrating the existence of tunneling-related tax avoidance and its economic consequences, this study sheds light on the emerging agency perspective on tax avoidance.

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Why is it important?

First, we are among the first to provide direct empirical evidence of the association between tax avoidance and tunneling in a principal-principal agency setting. Our findings are consistent with the interpretation of tax avoidance as serving to shield the detection of tunneling activity (Desai and Dharmapala 2006), as generating additional cash for tunneling, or both. Second, We extend these studies by investigating how the market values firms in which tax avoidance is highly correlated with tunneling. Using a sample of listed firms in the largest emerging market, we find that when tax avoidance is coupled with rent extraction, the agency costs substantially offset the benefits of tax savings. Therefore, tax avoidance is not necessarily always a ‘‘good thing’’ for outside investors. Our findings can help investors understand when tax avoidance is less likely to bring value. Finally, we add to the literature on corporate governance, specifically in relation to tunneling. In contrast to most U.S. studies, which largely focus on principal-agent problems, we examine the issue from a principal-principal agency perspective. Our finding that the practice of tunneling-related tax avoidance is affected by the investor protection environment has implications for most emerging economies in which ownership is highly concentrated and investor protection is generally weak, such as Russia, Laos, Vietnam, India, Brazil, and other central and eastern European countries (e.g., World Bank 2012, 2013).

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