Firms often undertake activities that do not necessarily increase cash flows (e.g., costly investments in corporate social responsibility, or CSR), and some investors value these non-cash activities (i.e., they have a "taste" for these activities). We develop a model to capture this phenomenon and focus on the asset-pricing implications of differences in investors' tastes for firms' activities and outputs. Our model shows that, first, investor taste differences provide a basis for investor clientele effects that are endogenously determined by the shares demanded by different types of investors. Second, because the market must clear at one price, investors' demands are influenced by all dimensions of firm output even if their preferences are only over some dimensions. Third, information releases cause trading volume, even when all investors have the same information. Fourth, investor taste provides a rationale for corporate spin-offs that help firms better target their shareholder bases. Finally, individual social responsibility can lead to corporate social responsibility when managers care about stock price because price reacts to investments in CSR activities.
This study empirically examines the role of risk sharing between taxable investors and the government on the relation between capital gains taxes and expected returns. Specifically, using an international panel from 26 countries over the period 1990 to 2004, we find evidence that the general positive relation between capital gains taxes and expected returns becomes weaker or even reverses when (i) a firm’s systematic risk is high, (ii) the market risk premium is high, or (iii) the risk-free rate is low. The results are particularly pronounced in countries with substantive changes in tax rates, more trust in government institutions, less integrated and less liquid capital markets, and lower foreign institutional ownership as well as around substantive increases and decreases in the risk parameters. We corroborate our findings in a single country setting, using the 1978, 1997, and 2003 capital gains tax rate changes in the United States as events. Our results underscore the importance of macroeconomic and firm-specific factors in determining the effect of tax capitalization, and suggest that tax rate changes can sometimes have opposite valuation implications than what policymakers have in mind.
We identify a pecuniary externality that arises when firms engage in tax avoidance. As more firms avoid tax, the cost of capital increases for all firms, even those that do not engage in such strategies. The intuition behind this prediction is that firms share risk with the government via taxation. The lower the tax rate applied to a firm’s earnings, the more risk that is borne by its shareholders relative to the government. As a meaningful percentage of firms avoid taxes, the variance of the market’s after-tax cash flow increases. Consequently, the covariance risk of all firms increases, which in turn translates into a higher cost of capital for all firms. Consistent with our prediction, we find that firms’ implied cost of capital is negatively related to the annual median long-run cash effective tax rate (Cash ETR) in the economy. The result holds both for firms with high and low long-run Cash ETRs, suggesting that the effect exists even for non-tax-avoiding firms. The pecuniary externality is weaker for those firms whose cash flow covaries less with the market cash flow, exactly as our intuition predicts. Finally, consistent with our prediction that tax avoidance by more firms increases the variance of the market cash flow, we find that the annual median long-run Cash ETR is significantly negatively related to the variance in annual aggregate earnings growth.
This study examines the costs and benefits of uniform accounting regulation in the presence of heterogeneous firms who can lobby the regulator. A commitment to uniform regulation reduces economic distortions caused by lobbying by creating a free-rider problem between lobbying firms at the cost of forcing the same treatment on heterogeneous firms. Resolving this trade-off, an institutional commitment to uniformity is socially desirable when firms are sufficiently homogeneous or the costs of lobbying to society are large. We show that regulatory intensity for a given firm can be increasing or decreasing in the degree of uniformity, even though uniformity always reduces lobbying. Our analysis sheds light on the determinants of standard-setting institutions and their effects on corporate governance and lobbying efforts.
This paper studies the propensity of firms to commit to disclose information that is subsequently biased, in the presence of other firms also issuing potentially biased information. An important aspect of such an analysis is the fact that firms can choose whether to disclose or withhold information. We show that allowing the number of disclosed reports to be endogenous introduces a countervailing force to some of the empirical predictions from the prior literature. For example, we find that as more firms issue reports or as the correlation across firms’ cash flows increases, the firm biases its report less. However, when we treat firms’ disclosure choices as endogenous, we show that the number of firms that commit to disclose decreases as the correlation across these cash flows increases, and this, in turn, offsets the direct effect of the correlation on bias.
Using hand-collected data on the portion of firms’ effective tax rates (ETRs) attributable to tax reserve changes over the 2004-12 period, we examine how investor response to income tax expense changes post FIN 48 enactment. Consistent with investors viewing tax expense as value lost to taxes paid, in the pre-FIN 48 period we find that abnormal returns surrounding annual earnings announcements are negatively related to a firm’s ETR and that abnormal returns surrounding 10-K filing dates are negatively related to the portion of the ETR attributable to tax reserve changes. In the post-FIN 48 period, both relations become significantly less negative and are not statistically different from zero, suggesting that FIN 48 reduces the value relevance of income tax expense. However, the muted reaction in the post-FIN 48 period is confined to firms for which we expect income tax expense to suffer the greatest decrease in value relevance (firms that experience large reserve reversals due to statute of limitation lapses and small reversals due to settlements), indicating that investors understand the differential impact of FIN 48 on tax reserve accruals.