(w/ D. Dharmapala) Journal of Financial Economics 79, no. 1 (January 2006), 145-179.
This paper analyzes the links between corporate tax avoidance and the growth of high-powered incentives for managers. We develop a simple model that highlights the role of feedback effects between tax sheltering and managerial diversion in determining how high-powered incentives influence tax sheltering decisions. Then, we construct an empirical measure of corporate tax avoidance - the component of the book-tax gap not attributable to accounting accruals - and investigate the link between this measure of tax avoidance and incentive compensation. We find that increases in incentive compensation tend to reduce the level of tax sheltering, in a manner consistent with a complementary relationship between diversion and sheltering. In addition, consistent with a prediction of our model, we find evidence suggesting that this negative effect is driven primarily by firms with relatively weak governance arrangements. Our results may help explain the growing cross-sectional variation among firms in their levels of tax avoidance, the "undersheltering puzzle," and why large book-tax gaps are associated with subsequent negative abnormal returns.