Equity Compensation and Tax Avoidance: Incentive Effect or Tax Benefits?

Abstract

We examine two competing explanations for the negative relation between equity compensation and tax avoidance documented in prior research. The first explanation suggests that equity compensation aligns managerial interests and reduces managers’ incentives to invest in tax avoidance schemes that facilitate rent extraction. The second explanation predicts that tax benefits from equity compensation reduce firms’ demand for additional tax avoidance by lowering its marginal benefits. We find evidence that the tax benefits from equity compensation, and not incentive alignment, drive the observed negative relation. Our findings suggest that researchers should consider the tax benefits of equity compensation to be of primary importance and control for these benefits when studying tax avoidance. Further, our results challenge the theory that managers use tax avoidance to facilitate rent extraction. Studies that rely on nefarious managerial behavior to motivate tax avoidance in the context of agency problems should reconsider the validity of this theory.

Keywords: Tax avoidance, equity incentives, tax benefits from equity compensation

JEL Classification: H25, M41, M52