Savannah (Yuanyuan) Guo, Sabrina Chi and Kirsten A. Cook
INTRODUCTION
A popular research stream in the tax accounting literature focuses on corporate tax avoidance. One area that draws a widespread interest is the determinants of corporate tax avoidance, especially after Shackelford and Shevlin (2001) expressed a demand for more research in understanding the cross-sectional differences in firms’ willingness to avoid taxes. The extant literature has studied mostly internal determinants of corporate tax avoidance, such as how firms with various characteristics, tax-planning opportunities, and managerial incentives are able to avoid more taxes.1 Each of these previously examined determinants encourages managers and their firms to engage in more tax-avoidance activities. In this chapter, we investigate whether firms attempt to respond to one external factor, short selling, by strategically reducing their tax-avoidance activities.
Compared to taking a long position in a security, short selling is more risky and costly, as short sellers trade on securities they do not directly own. Therefore, short sellers will not execute a transaction unless they expect that security’s price to fall by a sufficient amount to compensate for the costs and risks of shorting (Diamond & Verrecchia, 1987). Prior literature suggests that short sellers hold an information advantage over retail investors and even analysts (Drake, Rees, & Swanson, 2011; Khan & Lu, 2013). When short sellers concentrate to bet on a specific security’s price decline, this high short-interest level signals to the market that the targeted stock is overvalued relatively to its fundamentals, and the stock price is likely to decrease (i.e., greater stock price crash risk). In fear of this negative signal that high short interest can send to firms’ existing and prospective investors, prior research finds that managers respond to high short interest by decreasing discretionary accruals (and the likelihood of marginally beating earnings targets) and adjusting their disclosure policy to reduce bad news forecasts (Fang, Huang, & Karpoff, 2015; Li & Zhang, 2015).
To avoid the chance of questionable tax positions being detected, scrutinized, and overturned by taxing authorities, tax-avoidance activities often have complex structures. These complex structures correspondingly increase the complexity of financial reporting and often signal hidden bad news. For example, Enron used tax-shelter arrangements to manipulate earnings while preventing investors from understanding the source of the fabricated revenue (JCT, 2003). As bad news associated with misleading tax-avoidance activities accumulates, firms’ stock price crash risk significantly increases (Kim, Li, & Zhang, 2011). This risk is exacerbated when a firm experiences high short interest, a period when a large number of sophisticated investors trade on a firm’s anticipated stock price declines by shorting the firm’s shares for a profit. Because managers closely monitor their firms’ market prices and face strong incentives to stave off stock price crashes (Bergstresser & Philippon, 2006; Burgstahler & Dichev, 1997), we argue that, when short-interest levels are high and the stock price is more sensitive to firm-specific bad news, it is reasonable to expect firm managers to constrain negative-signal hoarding activities, such as tax-avoidance activities (Grullon, Michenaud, & Weston, 2015).
To measure tax avoidance, we use a variety of proxies calculated from financial statement data. Specifically, we use four proxies following prior literature: cash and GAAP effective tax rates (ETRs), discretionary permanent book-tax differences, and tax-shelter scores (Frank, Lynch, & Rego, 2009; Gallemore & Labro, 2015; Wilson, 2009). To measure short interest, we use open short-interest positions reported eight and a half months before the current fiscal year-end (i.e., three and a half months after the previous fiscal year-end) so that short sellers may digest the financial statements from the previous fiscal year before taking (or not taking) short positions in firms’ securities.2
Consistent with our hypothesis that short-selling curbs tax avoidance, we find that high short interest observed during the fourth month after the previous fiscal year-end is positively associated with subsequent cash and GAAP ETRs (i.e., less tax avoidance). Further, as predicted, we find strong negative associations between short-interest levels and our two more egregious tax-avoidance proxies – discretionary permanent book-tax differences and tax-shelter scores – indicating that short selling has a strong constraining effect on more aggressive tax-avoidance activities.
We perform several additional analyses and robustness tests. First, we use two-stage least squares (2SLS) estimation to address endogeneity concerns and bolster the causal inferences that we draw from our results. Specifically, in our first-stage model, we use the industry-year mean level of short interest as our instrumental variable (IV) to predict firm-specific short interest. We verify that this variable is not a weak instrument. Then, in our second-stage model, we replace actual short-interest levels with the predicted values from our first-stage model and find consistent results for three of four tax-avoidance outcome variables.
Second, we partition our sample into low, middle, and high analyst coverage subsamples. As prior literature suggests that firms with less analyst following are more likely to experience a stock price crash risk related to tax avoidance, we expect managers of these firms to face greater incentives to reduce tax avoidance under the scrutiny of short sellers. However, contrary to our expectation, we find that results are more pronounced in firms with more analyst coverage (i.e., the high analyst coverage tercile). One possible explanation is that managers of firms with more analyst coverage tend to be more accountable to e...
