Two faces of product market competition and tax avoidance

Abstract

This paper investigates the effect of product market competition on a firm’s tax avoidance behavior. We develop a theoretical model showing that a greater product market competition could increase the managerial incentive of tax avoidance due to a “threat-of-punishment” effect but decrease shareholders’ incentive of tax avoidance due to a “value-of-tax-saving” effect, resulting in an inverted U-shape relationship between product market competition and tax avoidance. Moreover, the turning point of the inverted U-shape relationship is a function of a firm’s productivity and corporate governance. Empirically, we find consistent evidence that the effect of product market competition on a firm’s tax avoidance has an inverted U-Shape and such an effect varies across firms with different productivity and corporate governance. Our analysis highlights the complex effect of product market competition on a firm’s tax avoidance activities. Valuation Insight: As product market competition increases, tax avoidance by firm first increases and then falls. This result highlights the fact that the effect of corporate tax payments in firm value is even more complex than previously considered.