Short Selling and Corporate Tax Avoidance

Abstract

This study examines short selling as one external determinant of corporate tax avoidance. Prior research suggests that short sellers have information advantages over retail investors, and high short-interest levels are a bearish signal of targeted stock prices. As a result, when short-interest levels are high, managers have been shown to take actions to minimize the negative effect of high short interest on firms' stock prices. Tax-avoidance activities may convey a signal of bad news (i.e., high stock price crash risk). We predict that, when short-interest levels are high, managers possess incentives to reduce firm tax avoidance in order to reduce the associated stock price crash risk. Consistent with this prediction, we find that short interest is negatively associated with subsequent tax-avoidance levels. This effect is incremental to other factors identified by prior research. We conclude that short selling significantly constrains corporate tax avoidance.

Short-sale deregulation and corporate tax aggressiveness: evidence from the Chinese market

“…We can also see from the table that the firms added to the shortselling designated list tend to engage in aggressive tax avoidance activities to a lesser extent than the firms not allowed to be shorted. These findings are consistent with findings in prior literature (e.g., Guo, Chi, and Cook 2018;Kim, Lu, and Peng 2020), but differ from those in Luo et al (2020), who used the commonly used ETR and Cash ETR to measure tax avoidance in China. Tang, Mo, and Chan (2017) argued that a limitation of the commonly used ETR measures is that they do not distinguish tax savings from tax preferences and aggressive tax reporting.…”

“…In order to better understand the roles short selling plays in emerging markets, in this research, we also use Chinese data and conduct a thorough analysis to investigate the relationship between shortselling and tax aggressiveness. However, we find that short selling deters tax aggressiveness in Chinese listed companies, consistent with the studies of Guo et al (2018) and Kim et al (2020) based on U.S. settings. Meanwhile, we also demonstrate that the LNT empirical work can be challenged in terms of both data selection and the methodology employed, which may invalidate their results.…”

“…We can therefore see that, in the presence of short sellers, firms may be motivated to avoid paying taxes so as to generate cash internally, as a substitute for costly external funds. In summary, the extant studies, particularly LNT, Kim et al (2020), and Guo et al (2018), prompt conflicting predictions and present contradictory findings as to whether the short-selling mechanism leads firms to engage in greater or lesser aggressive tax avoidance.…”

“…However, their results and conclusions are disparate. Guo, Chi and Cook (2018) conducted the first empirical study to examine the effect of short selling on corporate tax avoidance. Kim, Lu, and Peng (2020) examined a similar relationship using the pilot program on short sales in Regulation SHO.…”

“…First, and most importantly, we point out flaws in LNT and apply a more appropriate key variable construction, and sample and control variable selection, to investigate the impact of short selling on tax aggressiveness in China 1 . Second, differing from Guo et al (2018) and Kim et al (2020), our study is based on the Chinese market, the world's largest emerging market, where a pilot short-selling scheme launched in March 2010 lifted the ban on margin trading and short selling for designated stocks. Chinese public firms are widely characterized by poor corporate governance and a large gap between control rights and cash-flow rights, which enable and stimulate insiders to divert corporate resources (Firth et al 2007).…”