shareholder ownership and tax avoidance
TRANSCRIPT
MSc Accountancy & Control
Shareholder ownership and tax
avoidance.
Financial Accounting
Karn Shah
10262156
Draft Version
Date: 22-06-2015
Dr. W.H.P Janssen
Word count: 10.307
Shareholder ownership and tax avoidance
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Statement of Originality
This document is written by student Karn Shah who declares to take full responsibility for the
contents of this document. I declare that the text and the work presented in this document is
original and that no sources other than those mentioned in the text and its references have
been used in creating it. The Faculty of Economics and Business is responsible solely for the
supervision of completion of the work, not for the contents.
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Contents
Abstract .................................................................................................................................................. 4
1.0 Introduction ..................................................................................................................................... 5
2.0 Literature review and hypotheses .................................................................................................. 7
2.1.1 Tax avoidance definitions .......................................................................................................... 7
2.1.2 Benefits and costs involving tax avoidance ................................................................................ 8
2.2 Agency Theory ........................................................................................................................... 10
2.3.1 Concentration of ownership definition ..................................................................................... 11
2.3.2 Types of investors .................................................................................................................... 12
2.4 Hypothesis ................................................................................................................................... 12
3.0 Research Methodology .................................................................................................................. 13
3.1 Sample selection .......................................................................................................................... 13
3.2 Variable alternatives .................................................................................................................... 14
3.2.1 Tax avoidance measures ........................................................................................................... 14
3.2.2 Concentration of ownership measurements .............................................................................. 15
3.3 Variables measurement ............................................................................................................... 16
3.3.1 Tax avoidance ........................................................................................................................... 16
3.3.2 Concentration of Ownership..................................................................................................... 17
3.3.3 Control variables ...................................................................................................................... 17
3.4 Model .......................................................................................................................................... 19
4.0 Descriptive statistics & Empirical results ................................................................................... 19
4.1 Descriptive Statistics ................................................................................................................... 19
4.2.1 Results ..................................................................................................................................... 21
4.2.2 Discussion ............................................................................................................................... 22
5.0 Sensitivity Analysis ........................................................................................................................ 23
5.1 Sensitivity analysis – 10% threshold ........................................................................................... 23
5.2 Sensitivity analysis – 20% threshold ........................................................................................... 25
6.0 Conclusion ...................................................................................................................................... 26
Bibliography ........................................................................................................................................ 28
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Abstract
This paper provides empirical evidence on the relationship between concentration of
ownership and the tax avoidance activities of a firm. More specifically, this paper questions
whether there is an association between the concentration of ownership and tax avoidance.
This is done to contribute to the growing stream of literature about shareholder concentration
and tax avoidance and to answer to the call for more empirical evidence. This paper also
stimulates the ongoing discussion about tax avoidance as a societal issue.
To answer the proposed research question, a regression analysis will be conducted to
determine the relationship between the concentration of ownership and the tax avoidance of a
firm. The sample consists of 492 firm-year observations coming from a total of 125 firms.
The results show that there is no association between the concentration of ownership
and the amount of tax avoidance of a firm. This contradicts prior literature which states that
the concentration of ownership either has a positive or a negative relationship to tax
avoidance. The results can be contradicting because of a few reasons. The first reason is that
the sample is too small and did not capture all the effects of the entire population. The second
reason is that the measure used for tax avoidance did not capture all the effects of tax
avoidance.
This paper has a few limitations. One of the limitations is that the sample is too small
due to range constraints from the Blockholders database. This constraint resulted in another
limitation, which was the inability to use the long-run tax avoidance as there were not enough
year observations to compute this measure.
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1.0 Introduction Tax studies in general are found in various research fields such as accounting, finance,
economics and law, which makes tax studies very varying and comprehensive. This varying
aspect makes tax research particularly difficult, because every field has its own particular
interests and even their own languages (Hanlon & Heitzman, 2010). One of the topics within
tax research is tax avoidance. Tax avoidance is a fairly young and rising topic in the
accounting research (Hanlon & Heitzman, 2010). Dyreng, Hanlon & Maydew define tax
avoidance as anything that reduces the firm's cash effective tax rate. This means that tax
avoidance does not have to be anything illegal (2008).
Dyreng et al. found that firms are able to avoid taxes over a long period of time. They
developed a measure called "long-run cash effective tax rate" which describes the firm's
ability to avoid taxes over a long period of time for as long as ten years. They also discovered
that annual cash effective tax rates are not good predictors of long-run cash effective tax rates
(2008). So this study contributed mainly in a descriptive way by designing a measure for
long-run tax avoidance. But the authors did not know why some firms engaged in tax
avoidance and others did not and they let this question open for future research (Dyreng et
al., 2008). Hanlon & Heitzman state that there are multiple determinants for tax avoidance.
One of the reasons for tax avoidance could be the ownership structure of the firm (2010).
Desai & Dharmapala state that concentrated ownership leads to a greater incentive to
avoid taxes (2008). They base this on the theoretical notions of the agency theory, but there is
no empirical evidence to support this notion. The authors also discuss some other
determinants for tax avoidance such as: information systems, corporate control and high
powered incentives (Desai & Dharmapala, 2008). They continue by stating that the role of
taxes and ownership patterns have yet to be explored and they call for more empirical work
(Desai & Dharmapala, 2008). So this study mainly sets up a basis for future research by
implying that there is a certain relationship between the ownership structure of a firm and its
tax avoiding activities and calls for empirical research.
Chen et al. indirectly reply to that call for more empirical research. They found that
family firms with relatively few shareholders are less tax aggressive than their non-family
counterparts. These results show that family owners are willing to forgo tax benefits to avoid
the non-tax costs such as potential penalties and reputation damage (2009). So this research
also studied the link between the shareholder construction and tax avoiding activities and was
insightful by helping towards a better understanding of the impact of equity ownership and
agency conflicts on firms' tax avoiding activities. But this study was focused on family owned
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firms, which differ from non-family owned firms. While this piece of empirical evidence
showed the tax aggressiveness of family firms, which are highly concentrated firms,
compared to non-family firms, it left the tax aggressiveness of highly concentrated firms
compared to lowly concentrated firms open for future research.
The underlying notion for the relationship between the shareholder construction and
tax avoiding activities is the agency problem. According to Chen et al., firms with a high
ownership structure (i.e. less shareholders but with relatively high ownership per shareholder)
have a better managerial and shareholder interest alignment and therefore there are less
conflicts between the owners and managers (2009). Because there are less conflicts between
owners and managers, there will be more tax avoiding activities within a firm. However, there
is also some indication that highly concentrated firms may actually engage less in tax
avoiding activities. According to Hanlon & Heitzman, concentrated firms are more concerned
with long-term results and are worried about arising costs, such as reputational costs (2010).
Also, concentrated firms could engage in less tax avoiding activities because individuals have
intrinsic motivations on tax evasion and will compare these to their risks and highly
concentrated firms act more like individuals than non-concentrated firms.
The aforementioned disagreement in previous literature and the call for empirical
research makes it interesting to investigate the relationship between concentration of
shareholder ownership and tax avoidance. The following question will be investigated: is
there a relationship between the concentration of ownership and the tax avoidance of a firm?
Desai and Dharmapala state that tax avoidance and ownership patterns have yet to be
explored (2008). This thesis would contribute to the direct call for more empirical evidence on
this subject, which is a fairly new and undiscovered topic. To my knowledge there is little
empirical research done in the way this research will be done, therefore this research will
contribute to the growing stream of literature regarding tax avoidance and ownership
structure.
Tax avoidance is also a societal issue. It is seen as unethical to have big corporations
like Apple pay a relatively low amount of tax and meanwhile increase the tax burden on
civilians to push government bills (Doward, The Guardian, 2014). Conducting this research
could give more insight to the thought process of corporations that engage in tax avoiding
activities, which could result in more understanding on corporate tax avoiding activities.
The rest of the paper proceeds as follows: section two will cover the literature review
and hypothesis. This will be followed by section three that describes the sample used in the
research and the research design itself. In section four, the main results of the research will be
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discussed followed by section five, in which the sensitivity analyses are described. Lastly,
section six will conclude this paper.
2.0 Literature review and hypotheses In this section I will discuss three topics. First, in the literature review, I will discuss tax
avoidance, mainly explaining the definition of tax avoidance and the costs and benefits
resulting from tax avoidance. The second topic is the agency theory. First, I will give a
general explanation of the agency theory. After that I will try to make a link between the
agency theory and the problem that is being researched. The third topic discussed in this part
is the concentration of ownership. Also here I will begin by defining shareholder structure and
continue to discuss different types of investors. With these three topics discussed, a
hypothesis will be constructed.
2.1.1 Tax avoidance definitions
As stated earlier, tax avoidance is hard to define and measure. Tax studies are done across
many fields and therefore there is no single definition of tax avoidance (Hanlon & Heitzman,
2010). The most broad definition of tax avoidance comes from Dyreng et al., where they
studied a firm's ability to reduce their long-run cash effective tax rate in any way possible.
The authors defined tax avoidance as anything that reduced their long-run cash effective tax
rate (2008). These are mainly activities done in compliance with the law or those in gray-
areas. Hanlon & Heitzman build upon this notion and define tax avoidance as the reduction of
explicit taxes (2010). The difference between Hanlon & Hetzman's definition and Dyreng et
al.'s definition is that Hanlon & Heitzman do include illegal activities and identify different
types of tax avoidance. On the one hand are the types of tax avoidance that are perfectly legal,
and on the on the other hand would be the more aggressive and noncompliance types of
activities (2010).
These two definitions are accepted in the tax research community and are used in
various empirical researches. One of those researches is that from Kim et al. (2011). In this
research, the authors studied whether tax avoidance could be used as a predictor for stock
price crashes. The authors used the definition for tax avoidance as provided by Hanlon &
Heitzman (Kim et al., 2011). A different study that uses this definition is that from Chen et
al. (2010). This study was already briefly discussed and the authors of this study studied the
tax aggressiveness of family firms relative to the tax aggressiveness of non-family firms.
They defined tax aggressiveness as the downward management of taxable income through tax
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planning activities, including legal, illegal and grey-area activities (Chen et al., 2009). As we
have seen earlier, this definition corresponds with the definition given by Hanlon &
Heitzman (2010).
Something noteworthy is that Hanlon & Heitzman (2010) stated that tax avoidance is
hard to define because it exists in multiple research fields and that there is no generally
accepted definition. However, this was only brought to attention after Hanlon & Heitzman’s
paper (2010). This is because both Kim et al. (2010) and Chen et al. (2009) do not discuss
different definitions of tax avoidance. This could imply that there may have been more
obscurity on the definition of tax avoidance than previously thought and that Hanlon &
Heitzman emphasized on a previously uncharted matter (2010).
2.1.2 Benefits and costs involving tax avoidance
Before deciding whether avoiding taxes will be beneficial, the firm has to assess the tradeoff
between the marginal benefits against the marginal costs of avoiding taxes (Chen et al, 2009).
Considering tax avoidance, there are more types of costs than benefits. Usually, the benefits
are quite clear. The main benefit of avoiding taxes would obviously be saving cash so that it
can be used for other purposes such as reinvestments in the firm or for higher dividend
payouts. Therefore, in this section, the emphasis will lie on the costs involving tax avoidance.
One of the main elements involving tax avoidance is rent seeking behavior, also
known as rent extraction (Chen et al., 2009). These two definitions will be used
interchangeably from now on. According to Tullock, the concept of rent seeking is when a
firm or individual attempts to gain economic benefits without reciprocating this to the society
through wealth creation (1967). The term rent seeking was actually coined in 1974 by
Krueger (1974). Chen et al. refer to rent extraction as the non-value maximizing activities that
decision makers follow at the cost of shareholders. Some examples they give are: aggressive
financial reporting, perk consumption such as receiving target-related bonuses and related-
party transactions (2009).
For decision makers, there are some benefits regarding rent seeking. They can, for
instance, manage earnings to meet or beat their earnings benchmarks, which might result in a
monetary gain for them (Chen et al., 2009). Firms could also make use of tax shelters to save
on tax payments, which also could result in a personal monetary gain (Desai et al., 2006).
However, these rent seeking activities also bare costs with them. For instance, if a firm is
making use of illegal methods to avoid taxes, the IRS could impose penalties which obviously
would hurt the firms earnings (Chen et al., 2009). Another cost of rent seeking behavior is a
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potential price cut in the shareholder price. According to Chen et al. this can occur when other
shareholders become aware of the tax avoiding activities to extract rents and as a result bid
the firm price down (Chen et al., 2009). Basically, firms, or managers, can choose to practice
tax avoiding activities such as making use of tax shelters, that result in personal monetary
gain, which is a form of rent extraction. Managers can also make use of complex tax avoiding
activities to hide their intent of rent extracting activities (Chen et al, 2009; Desai &
Dharmapala, 2006).
Another type of cost that firms have to take into account are political costs.
Essentially, political costs are potential costs that can be imposed on the firm by external
parties as a result of political actions and or measures (Watts & Zimmerman, 1978).
According to Watts & Zimmerman, the political sector has an incentive to redistribute wealth
among various groups, and the corporate sector is particularly vulnerable to these
redistributions (1978). According to the political cost hypothesis, firms will tend to show
lower profits to steer away any attention from politicians by using different means, such as:
social responsibility campaigns, government lobbying and the selection of certain accounting
procedures (Watts & Zimmerman, 1978). By minimizing the attention to the firm's high
earnings, firms can minimize their potential costs as a result of politically imposed measures
(Watts & Zimmerman, 1978). Tax avoidance can be used as a method to influence potential
political costs. This means that when a firm is deciding on their level of tax avoidance, they
also should consider the potential political costs involved when the level of tax avoidance is
higher. This would mean that their earnings would be higher and would lead to increased
scrutiny from politicians, which could result in political costs (Watts & Zimmerman, 1978).
The last type of cost that will be discussed is reputational costs. Existing evidence
shows that there is a positive relationship between a firm's long-term performance and having
a good reputation (Roberts & Dowling, 2002). Reputation costs are costs that are incurred as a
result of a loss in reputation. An example of this is the 2010 BP oil spill, also known as the
'Deepwater Horizon oil spill.' As the events unfolded, starting on the 20th of April, BP's share
price dropped lower and lower. It went from $59.88 per share before the event, to $27.02 at its
lowest following a few months after the event1. In the study of Chen et al., it was shown that
family firms are less tax aggressive than non-family firms. This was a result of two factors:
concerns of getting a potential penalty imposed by the IRS and the concerns of losing
1 https://www.google.com/finance?q=NASDAQ%3ABP&ei=I4I_Vdn8PMSr8QOOx4HoDQ,
Dates: 16-04-2010, $59.88 & 25-06-2010, $27.02.
Shareholder ownership and tax avoidance
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reputation or family name (2009). So a firm has to take into account whether the loss of
reputation is worth the benefits of tax avoidance.
2.2 Agency Theory
In order to understand the relationship between tax avoidance and the concentration of
ownership of a firm, one must have some basic knowledge on the agency theory. This
information is also needed to construct a hypothesis. Therefore, I will explain the agency
theory in this section, following by the link between tax avoidance and ownership
concentration. After addressing these topics, I will construct a hypothesis.
Just like tax research, the agency theory is researched in various fields of studies such
as accounting, economics, finance and political science (Eisenhardt, 1989). The agency theory
describes the relationship between the principal and the agent. The agent is hired by the
principal to perform services on the principal’s behalf (Jensen & Meckling, 1976). Jensen &
Meckling state that there is a good chance that the agent will not act in the best interests of the
principal if both the agent and the principal are utility maximizers, meaning they act
according their own interests (1976). This divergence in interest can cause problems that
occur between shareholders (principal) and management (agent). These problems occur
because they each have their own goals or because the principle is unable to monitor (or
afford to monitor) the agent’s work (Eisenhardt, 1989). Another important problem between
the principal and the agent is the problem of risk sharing. The agent might have a different
attitude towards risk and therefore have different preferences. As a result, this could hurt the
principal's firm (Eisenhardt, 1989). In other words, the agency problem describes a conflict
of interests between the principal and the agent, where the agent (management) could be
interested in maximizing its own wealth instead of the firms wealth.
There are two distinct problems associated with the agency theory. The first one is the
moral hazard problem. Moral hazard is essentially the problem that the agent does not put in
enough effort in his work (Eisenhardt, 1989). In this case, the principal is taking the risk
without having the information whether the agent will work adequately. The agent however,
does know how much effort he will put in his work. This difference of information between
two parties is called information asymmetry. The second problem associated with the agency
theory is adverse selection. Adverse selection in the agency theory is the fact that agents can
claim to have certain skills for a job and that the principal is not able to verify these claims.
(Eisenhardt, 1989). This is also a form of information asymmetry.
There are some ways for the principal to align the agent’s interests with his own to
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minimize any agency conflicts (Jensen & Meckling, 1976). One way is to incentivize the
agent to act towards a behaviour that better fits the principal. This can be done for instance by
giving out bonuses when certain targets are met, or giving the agent a share of the equity so
that his motives are more in line with the principal’s (Jensen & Meckling, 1976). More
specifically, the increase in ownership results in less managerial opportunism according to
Jensen & Meckling (1976). The reasoning behind incentivizing is that the outcomes of the
agency contract coalign and the rewards are now dependent on the same actions. This results
in a reduction of the self-interest conflicts between principal and agent (Eisenhardt, 1989).
Another way to minimize agency conflicts is for the principle to verify the agent’s
behaviour, which is called monitoring. When the agent knows that the principal is able to
verify the agent’s behaviour, the agent is less likely to shirk and will behave in the interests of
the principal (Eisenhardt, 1989). An example of monitoring is having a board of directors that
monitors and restricts the management’s activity on behalf of the shareholders. Monitoring,
however, also includes costs. These monitoring costs make it, in most cases, impossible for
the principal to ensure that the agent is only taking decisions that are optimal for the firm
(Jensen & Meckling, 1976).
2.3.1 Concentration of ownership definition
The term concentration of ownership refers to the allocation of the shares between the
shareholders. If there is a low amount of shareholders with relatively more shares per
shareholder, then there is a high concentration of ownership. Therefore, the shares are
concentrated, meaning they are close together, and not dispersed (La Porta et al., 1998). The
definition of concentration of ownership seems to be unambiguous in previous literature. For
instance, Ding et al. do not give a definition of ownership concentration, which implies that
they assume that there is but one definition (2007).
The concentration of ownership of a firm has been used to study relationships between
various subject matters, but not a lot for the relationship with tax avoidance. One of the
pioneering works concerning shareholder concentration was the paper from La Porta et al.
This study examined the legal rules surrounding the protection of shareholders and creditors.
One of their findings was that the concentration of ownership of the largest public company is
negatively related to the investor protection (1998). Following this study, other researches
also have studied the concentration of ownership of firms, such as: Burkart & Panunzi (2006)
and La Porta et al (1999). After these studies, a few researchers started linking tax avoidance
with ownership structures.
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2.3.2 Types of investors There are different types of investors and these different types each have their own
characteristics (Bruton et al., 2010). These characteristics influence the investor’s behaviour
and lead to different choices. Therefore, in this section, I will discuss the two main types of
investors, institutional and transient investors, their behavior and how this might influence the
level of tax avoidance.
The first type of investors that will be discussed are the (non-transient) institutional
investors. Institutional investors are institutions that invest funds on behalf of others and
manage great amounts of equity. Some examples of institutional investors are: insurance
companies, hedge funds, retirement funds and mutual funds. According to Bushee,
institutional investors are more sophisticated than regular, individual investors (1998). This
means that they possess more knowledge than other types of investors. This is logical as they
are specialized in trading stocks. This sophistication results in more monitoring and more
disciplining the managers (Bushee, 1998). This could suggest that, because of more
monitoring and disciplining, firms with institutional investors have less tax avoidance.
The second type of investors are transient investors. According to Bushee, transient
investors are investors that usually hold a small amount of stocks in various companies and
trade for short term profits. They usually make their trading decisions based on short term
values such as current earnings (1998). Note that institutional investors can also be transient
investors as it is a kind of behaviour of the investor. Transient investors are more likely to
pressure managers to meet short term goals, so that the firm's stock price increases and the
investor can sell the stocks (Bushee, 1998). This could suggest that, because of more pressure
to meet short term goals, firms with transient investors have more tax avoidance.
2.4 Hypothesis
The agency theory as discussed in section 2.2, is the backbone of the relationship between tax
avoidance and concentration of ownership. For instance, Chen et al. state that firms with a
high ownership structure have a better managerial and shareholder interest alignment and
therefore there are less conflicts between the owners and managers (2009). This reduction in
conflicts between owners and managers results in more tax avoiding activities (Chen et al.,
2009). Desai & Dharmapala state that tax avoiding activities are viewed as an activity that
shareholders advocate (Desai & Dharmapala, 2006). Desai and Dharmapala also state that,
with regards to the agency theory, a highly concentrated ownership of a firm leads to a greater
incentive to avoid taxes (Desai & Dharmapala, 2008). This notion is also mentioned by
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Hanlon & Heitzman (2010) who state that firms with concentrated ownership may avoid
more taxes because the controlling owners benefit more from the tax savings.
On the other hand, there is also some indication that highly concentrated firms may
actually engage less in tax avoiding activities. According to Hanlon & Heitzman,
concentrated firms are more concerned with long-term results and are worried about arising
costs, such as reputational costs (2010). As discussed earlier, family firms, which generally
are concentrated, show less tax avoiding activities than non-family firms. This is because
family firms are willing to forgo tax benefits to avoid concerns from other stakeholders. These
concerns are about the family shareholders showing rent seeking behaviour and trying to hide
that through tax avoiding activities (Chen et al., 2009). Also, concentrated firms could engage
in less tax avoiding activities because individuals have intrinsic motivations for tax evasion
and will compare these to their risks. As concentrated shareholders have more to say about a
firm’s behaviour, the firm in general acts more like an individual than an non-concentrated
firm (Hanlon & Heitzman, 2010).
As we have just seen, there is some disagreement in the literature concerning the
relationship between tax avoidance and shareholder concentration. It can either be a positive
relationship, where a high concentration of ownership results in more tax avoiding activities,
or a negative relationship, where a high concentration of ownership leads to less tax avoiding
activities. Therefore, to test this relationship, I have constructed the following null hypothesis:
H0: There is no association between the concentration of ownership and the amount of tax
avoiding activities of a firm.
3.0 Research Methodology In the following section I will describe the sample selection, following with the different
measures that can be used as a proxy for tax avoidance. After that, I will discuss the different
measures for concentration of ownership. After discussing the different alternatives for tax
avoidance and concentration of ownership, I will make a choice between the different
measures and explain why those measures were used. Lastly, I will discuss the empirical
model used in the research.
3.1 Sample selection
The sample of firms in this research are derived from the S&P SmallCap 600 (S&P 600). The
S&P 600 is a stock market index that measures the small-cap segment of the U.S. equity
market. This stock market index is ideal for this research as it is more likely that there are
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more firms with a lower number of shareholders due to the size of the market capitalization of
the firms.
Two databases are used to gather all the data that is needed to conduct this research.
Firstly, the database Blockholders is used to gather information about the firms' concentration
of ownership. Due to scope limitations in this database, the sample period is 1996-2001.
Secondly, the database Compustat is used to gather information about tax avoidance and also
the information on control variables are extracted from this database.
The data from the two databases results in a total of 2944 firm year observations. Most
of the observations are from Compustat, which had information on 471 firms. Blockholders,
however, only had information on 180 firms, making the sample much smaller. The
Blockholders database does not have any information on the remaining 291 firms and there is
no explanation why. It is unclear whether these firms did not have any large shareholders
during that time period, or that the database was unable to collect relevant information on
those firms. Merging the two datasets and removing missing data results in 492 firm year
observations coming from a total of 125 firms, forming the actual sample.
With this sample, an archival database research will be conducted. More specifically, a
regression analysis will be conducted to determine the relationship between the concentration
of ownership and the tax avoidance of a firm.
3.2 Variable alternatives
In the following section I will discuss the different measures that can be used to measure tax
avoidance and shareholder concentration. After discussing the different measures, a choice
will be made later on in section 3.3.
3.2.1 Tax avoidance measures
There are many ways to measure tax avoidance and each measure has its own advantages and
disadvantages. Also, not every measure is suitable for every research question. In this section
I will discuss the main, usable measures, their meaning and their advantages and
disadvantages.
One of the more common types of tax avoidance measures used in tax research is the
'effective tax rate' (from now on: ETR) measure. This measure incorporates the average rate
of tax per dollar of income or cash flow (Hanlon & Heitzman, 2010). This measure is
determined by dividing an estimate of the tax liability of a firm by a measure of before-tax
profits or cash flow (Hanlon & Heitzman, 2010). For example, to calculate the GAAP ETR
one has to divide the 'worldwide total income tax expense,' which in this case is the estimate
Shareholder ownership and tax avoidance
15
of the tax liability, by the 'worldwide total pre-tax accounting income,' which is the before tax
profit (Hanlon & Heitzman, 2010). The GAAP ETR uses the total income tax expense, which
means that if a firms defers taxes, this will not alter the GAAP ETR, as it is still a tax expense.
Another measure, the Cash ETR, uses the same denominator, but for the numerator it uses
'worldwide cash taxes paid' which means that it is affected by tax deferral strategies. At the
same time, Cash ETR is not affected by changes in tax accounting in accruals, but GAAP
ETR is (Hanlon & Heitzman, 2010). This shows that even the slightest change in variables
can result in an essential change in result.
Additionally, there is another type of ETR, which is more focused on the long term
implications of tax avoidance. This is the 'Long-run ETR' and was developed by Dyreng et al.
(2008). This measure is computed with the same variables used in the Cash ETR, but here the
sum of ten years of those variables is used. The main benefit of using this method is that it
takes away the year-to-year volatility in annual effective tax rates (Dyreng et al., 2008). One
of the detriments of using all ETR variants is that they do not distinguish between real
activities that are tax-favoured, avoidance activities that are meant to actually avoid taxes and
targeted tax benefits from lobbying activities (Hanlon & Heitzman, 2010). This can result in
taking into account non-tax avoiding activities.
Another type of measurement for tax avoidance is the unrecognized tax benefit. This
measure is used as a proxy for tax avoidance and can be obtained directly from the FIN 48
disclosure of a firm (Hanlon & Heitzman, 2010). FIN 48 is an official interpretation issued by
The Financial Accounting Standards Board in 2006 and its purpose is to clarify the
accounting for uncertainty in income taxes. This is done by providing the criteria used to
recognize and measure the uncertain tax benefits (Cazier et al., 2009). According to Hanlon &
Heitzman, one of the underlying determinants for unrecognized tax benefits are the financial
reporting incentives. Managers may use the unrecognized tax benefit to manage earnings
upwards and it is therefore also used as a proxy for earnings management (2010). This
measure is subjected under the judgement of management which makes it less objective.
3.2.2 Concentration of ownership measurements
According to Sjögren, Overland & Mavruk, choosing your measure for the concentration of
ownership of a firm is important. A different choice of measure can lead to different
conclusions (2012). Therefore, I will discuss a few different measures so that I will be able to
make a choice between these measures for the concentration of ownership, which will be used
when testing the hypothesis.
Shareholder ownership and tax avoidance
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There are a few different ways to measure the concentration of ownership of a firm.
One is to take the average percentage of common shares owned by the three largest
shareholders of the firm. This technique was developed by La Porta et al. (1998), but also
used by Ding et al. for their research (2007). An advantage of this type of measure is that one
can arrange a sample of firms from a low concentration of ownership to a high concentration
of ownership, comparably to Sloan's study, where he ranked firms based on their amount of
accruals (1996).
Another type of measurement is called the 'weakest link principle.' With this principle,
a firm is concentrated if it has an owner with more than a certain threshold of shares or voting
power (Edwards & Weichenrieder, 2009). This threshold can be for example 5%, 10% or
20%. If no one shareholder can be identified meeting this threshold, then the firm is not
concentrated but dispersed (Edwards & Weichenrieder, 2009). An advantage for this method
is that one can divide a sample of firms into two groups, one group of with firms that meet the
threshold and one group of firms that do not meet the threshold. Choosing between these
measures will rely on the research methodology and that will be discussed in the following
sections.
3.3 Variables measurement
3.3.1 Tax avoidance
As discussed earlier, there are a few different methods to measure tax avoidance. One of those
measures is the Long-run ETR as described in Dyreng et al. (2008). The main benefit of
using this method is that it takes away the year-to-year volatility in annual effective tax rates
(Dyreng et al., 2008). However, this method is only effective when the sample period is a
longer term, such as ten years (Dyreng et al., 2008). As stated earlier, due to scope limitations
of the Blockholders database, the sample period of this research is only six years, and even
then, there are not always six years of data for every firm. For this reason, choosing the Long-
run ETR as a tax avoidance measure, will not have any added value in this research.
Therefore, instead of using the Long-run ETR, the yearly GAAP ETR will be used
such as in the paper of Chen et al. (2009) and described in the paper of Dyreng et al. (2008).
The GAAP ETR is calculated as:
Shareholder ownership and tax avoidance
17
where i stands for firm and t stands for year. This dependent variable will be called
GAAPETR. This measure captures the average rate at wich a firm is taxed as it divides the tax
expense by the taxable income (Dyreng et al., 2008). The main benefit of this measure is that
if a firm defers taxes, it does not alter the tax expense, capturing any methods of avoiding
taxes with the use of accruals (Hanlon & Heitzman, 2010). However, this measure does not
take away any year-to-year volatility, which could result in incomplete results (Dyreng et al.,
2008). Any values lower than 0 and higher than 1 will be dropped, in line with the research of
Chen et al. (2009).
3.3.2 Concentration of Ownership
One of the ways to measure concentration of ownership is to take the average of the largest
three shareholders of the firm (La Porta et al., 1998). The database Blockholders, however,
does not provide any information on individual shareholders, making this approach unusable.
Another approach to measure concentration of ownership is the weakest link principle
(Edwards & Weichenrieder, 2009). With this measurement, a firm is concentrated if a
shareholder has more than a set amount of shares or voting power. The set amount can be for
instance 5%, 10%, 25% or anything else that could imply a concentrated ownership. This
method will be used in this research. As a threshold, I have chosen 5% because shareholders
with at least 5% of shares of a company are called 'major shareholders' (Sjögren et al., 2012).
This independent variable will be called CONCENTRATED and is a dummy variable. This
means that CONCENTRATED is measured as an indicator variable coded as ‘1’ if the firm
has one or more shareholders with 5% or more of total shares and as ‘0’ otherwise. The
Blockholder database provides data for the percentage of shares held by a blockholder,
corrected for overlapping shareholdings (Dlugosz et al., 2006). The dummy variable is
calculated as follows:
where i stands for firm and t stands for year.
3.3.3 Control variables
Besides the independent variable CONCENTRATED, a number of control variables are used.
As this research is focused on the relationship between shareholder concentration and tax
avoidance, any outside factors influencing the results are unwanted. Therefore, there are a few
control variables that have to be taken into account.
Shareholder ownership and tax avoidance
18
The first control variable is the leverage of a firm, which will be called LEV. This
variable is calculated as follows:
.
where i stands for firm and t stands for year. Firm leverage is used as a control variable
because prior literature shows us that highly leveraged firms have lower effective tax rates
than low leveraged firms (Stickney & McGee, 1982). This would mean that firms with a high
amount of leverage will show higher tax avoidance in the research model, irrespective of the
firm’s concentration of ownership. Therefore, leverage needs to be controlled for. High
leveraged firms have lower effective tax rates because there are a lot of tax benefits of debt.
This is because firms in the US are taxed on their equity and not on their debt (Graham,
2000).
The next control variable is the size of a firm, which will be called SIZE. This variable
is calculated as follows:
where i stands for firm and t stands for year. The natural logarithm of firm size is taken to
eliminate the big differences in firm size. Firm size is controlled for because prior literature
shows us that larger firms have higher effective tax rates than smaller firms (Zimmerman,
1983). For the research model, this would mean that the larger firms will show lower tax
avoidance, whether or not the firm has a high concentration of ownership and therefore, the
size of a firm needs to be considered. According to Zimmerman, large firms have higher
effective tax rates because they are more subject to political scrutiny, resulting in higher
political costs (1983).
The last control variable is the market-to-book ratio of a firm, which proxies the
growth of a firm and will be called MARKBOOK (Chen et al., 2009). This variable is
calculated as follows:
where i stands for firm and t stands for year. Firm growth is a control variable because
growing firms may make more investments in tax beneficial assets (Chen et al., 2009). In this
research model, that would mean that growing firms will show higher tax avoidance, whether
Shareholder ownership and tax avoidance
19
or not the firm has a high concentration of ownership. For this reason, firm growth needs to be
controlled for.
3.4 Model
To test whether shareholder concentration is associated with tax avoidance, the following
regression model will be used:
where i stands for firm and t stands for year. As stated earlier, the dependent variable is
calculated by using the GAAP ETR of a firm. If highly concentrated firms conduct more tax
avoiding activities than low concentrated firms, is expected to be negative. This is because
the lower the ETR is, the more tax is avoided. If highly concentrated firms conduct less tax
avoiding activities, then is expected to be positive. If there is no correlation between tax
avoidance and equity of ownership, the is expected to be close to 0. The control variables
are used to capture possible relationships between tax avoidance and the concentration of
ownership that could otherwise influence the results.
4.0 Descriptive statistics & Empirical results
In this section the descriptive statistics and their meanings will be discussed. Afterwards the
empirical results of the research will be discussed.
4.1 Descriptive Statistics
The descriptive statistics for tax avoidance, shareholder ownership and the control variables
are illustrated in table 1.
Table 1: Descriptive Statistics
Variable Observations Mean
Standard
Deviation Median
Min Max
GAAPETR 492 .3512 .0866 .3646
0 .7571
CONCENTRATED 492 .8434 .3637 1
0 1
LEV 492 .1827 .1436 .1792
0 .6471
SIZE 492 6.2813 .7150 6.2924
4.3823 9.5648
MARKBOOK 492 2.2252 3.8616 1.9002
-73.5788 17.6199
Shareholder ownership and tax avoidance
20
The GAAPETR is 0.3512 which means that the firms in this sample are, on average, taxed for
35,12% on their pretax income. The standard deviation is relatively low, which means that
there is not much of a dispersion regarding the effective tax rate among the different firms in
the sample. Just like in the paper of Chen et al. (2009), the range of effective tax rate is
between 0 and 1.
The dummy variable CONCENTRATED has a mean of .8434, which means that
84,34% of the firms in the sample have one or more shareholders with 5% or more of the total
shares. This shows that the majority of the sample has a concentrated ownership structure,
which may result in an under-representation of the non-concentrated firms.
Table 2 gives an overview of the correlation between the variables. The values in
parentheses are the p-values of the correlation.
GAAPETR CONCENTRATED LEV SIZE MARKBOOK
GAAPETR 1
-
CONCENTRATED -0.0442 1
(0.3279) -
LEV 0.1418 -0.1513 1
(0.0016) (0.0008) -
SIZE 0.0715 -0.0632 -0.0773 1
(0.1133) (0.1613) (0.0867) -
MARKBOOK 0.2039 -0.0046 -0.1784 0.1741 1
(0.0000) (0.9196) (0.0001) (0.0001) - Table 2: Correlation Matrix
The independent variable and the control variables are not highly correlated with each other,
the highest correlation is between the leverage of a firm and its market-to-book ratio, which is
-0.1784. This means that a higher market-to-book ratio leads to a lower amount of leverage
which corresponds with previous literature from Binks & Ennew. They stated that high
growth firms may be adversely affected by credit constraints (1996).
The correlation between the variables LEV and CONCENTRATED is -0.1513 which
means that the ownership concentration of a firm is negatively correlated with the amount of
leverage. If a firm is more concentrated, it will have less leverage. This could be explained by
the fact that larger shareholders are not willing to accept the risk of the debt, because the
shareholders bear the majority of the risk (Jensen & Meckling, 1976).
The fact that the independent variable and the control variables are not highly
correlated with each other, means that there is no collinearity in the model, thus there is no
Shareholder ownership and tax avoidance
21
need to drop any independent variables.
The correlation between the dependent variable and the independent variable is very
low and has a high p-value, which indicates that it is close to zero. This means that there is no
correlation between the concentration of ownership and the effective tax rate of a firm. The
actual coefficient of CONCENTRATED will be discussed in the next section.
4.2.1 Results
In the following sections I will discuss the results of the regression analysis. I will analyze and
discuss the coefficients and their meaning.
Table 3 reports the results of the OLS regression analysis between the effective tax
rate of a firm and the concentration of ownership.
coefficient t-statistic p-value
CONCENTRATED -0.0029 -0.28 0.779
LEV 0.1111***2
4.11 0
SIZE 0.0054 1.02 0.31
MARKBOOK 0.0051***
5.1 0
Constant 0.2876***
7.91 0
Observations (N) 492
F-value 10.09
Prob > F 0
R-squared 0.0766
Adj R-squared 0.069
Table 3; Results of Regression Analysis
The null hypothesis states there is no association between the concentration of
ownership and the amount of tax avoiding activities of a firm. The coefficient
CONCENTRATED is slightly negative, but not significantly less than 0, which means that
the null hypothesis is not rejected. This means that, in this sample, there is no effect between
the concentration of ownership and tax avoidance activities, which is not in line with the
prediction that shareholder concentration is either positively or negatively associated with tax
avoidance. This does not align with the current literature, which states that a higher
2 *** indicates that the coefficient is significant at the one per cent level.
Shareholder ownership and tax avoidance
22
concentration of ownership either results in more tax avoiding activities (Desai &
Dharmapala, 2008; Chen et al., 2009) or less tax avoiding activities (Hanlon & Heitzman,
2010; Chen et al., 2009).
Another coefficient that contradicts prior literature, is the coefficient for the variable
LEV. This is the variable that determines a firm’s leverage. Table 3 shows that the coefficient
is significantly positive. This means that firms with a higher leverage have a higher effective
tax rate. In other words, firms with higher leverage practice less tax avoiding activities. This
is not in line with Stickney & McGee (1982), which stated the opposite.
The coefficient MARKBOOK, which proxies for firm growth, is also significantly
positive. This means that if a firms market-to-book ratio increases, they conduct less tax
avoiding activities. Growing firms have higher market-to-book ratios because their market
value is higher than their book value as a result of investors thinking that these firms are
undervalued (Chen & Zhao, 2006). This means that growing firms actually conduct less tax
avoiding activities than full-grown firms, which also contradicts previous literature.
4.2.2 Discussion
In the previous section, the results of the regression showed that the concentration of
ownership is not associated with tax avoiding activities, which is not in line with the
prediction nor with the previous literature. There might be a few reasons for this disagreement
between the results and prior literature.
One of the reason that could explain this difference is that the sample is quite specific
and small. The sample is small because the database Blockholders only has data on firms
from 1996 to 2001. Also, does it not have data for every firm in the S&P Smallcap 600. This
is understandable, as collecting information on the shareholder concentration is difficult and
not always available. The small sample might not be able to capture all the effects of the
entire population and therefore result in a different outcome. Also, as stated earlier, the
independent variable consists for 84,34% of firms with a concentrated ownership structure.
This could imply an under-representation of the firms with a non-concentrated ownership
structure.
A second reason could be that the measure used for tax avoidance, GAAP ETR, did
not take away the year-to-year volatility and it did not reflect deferred taxes as tax avoidance.
According to Dyreng et al., there are two disadvantages to using the GAAP ETR. The first
one is that this measure does not take away any year-to-year volatility as it is an annual
measure (2008). Another disadvantage is that GAAP ETR includes both current and deferred
Shareholder ownership and tax avoidance
23
taxes and that means that the GAAP ETR will not reflect tax avoidance in the form of
deferring taxes (Dyreng et al., 2008). It could be that these aspects have caused different
results.
Another reason for conflicting results could be that the threshold for the concentration
of ownership was chosen too low. For a firm to be concentrated in this research, it has to have
one or more shareholders with 5% or more of the total shares, this was done in line with
Sjögren et al.’s paper (2012). However, it is possible that the effects of large shareholders are
better represented by shareholders with a larger percentage of shares than 5% (Sjögren et al,
2012). For this reason, a few sensitivity tests concerning the threshold will be conducted
These will be discussed in the next chapter.
5.0 Sensitivity Analysis In the following section some additional analyses will be conducted to test whether a different
threshold for the concentration of ownership has an effect for the outcome of the regression.
There is a lot of subjectivity in determining the threshold for a firm with a concentrated
ownership and using a different measure can lead to different results (Sjögren et al, 2012).
Therefore, to test whether these outcomes hold true for other thresholds, I conduct these
additional sensitivity analyses.
5.1 Sensitivity analysis – 10% threshold
I start by changing the dummy variable CONCENTRATED from being coded as ‘1’ if the
firm has one or more shareholders with 5% or more of total shares and as ‘0’ otherwise to
being coded as ‘1’ if the firm has one or more shareholders with 10% or more of total shares
and as ‘0’ otherwise. As stated earlier, determining the threshold for the concentration of
ownership requires some subjectivity and there are different thresholds that can be set
(Sjögren et al., 2012). The reason to raise the threshold to 10% specifically is because it is in
line with the empirical research of Maury & Pajuste, where they investigate whether having
multiple large shareholders has an effect on the valuation of the firm (2005).
Table 4 shows the descriptive statistics of the new regression with the new variable
called XCON, where X stands for the Roman numeral 10.
Shareholder ownership and tax avoidance
24
Table 4: Descriptive Statistics Sensitivity Analysis 10% Threshold
The descriptives of the old variables are unchanged. The mean of XCON is noticeably lower
at 0.2703 than the mean of CONCENTRATED. This means that, in this sample, 27.03% of
the firms have one or more shareholders with at least 10% of total shares. This shows that the
new threshold results in a higher representation of the non-concentrated firms. Also, this
means that the majority of the large shareholders possess somewhere between 5-10% of total
shares.
Table 5 shows the results of the regression between the effective tax rate and the new
variable XCON.
Coefficient t-statistic p-value
XCON 0.0013 0.15 0.879
LEV 0.1127***3
4.2 0
SIZE 0.0056 1.03 0.301
MARKBOOK 0.0052***
5.11 0
CONSTANT 0.2840***
8.27 0
Observations (N) 492
F-value 10.08
Prob > F 0
R-squared 0.0765
Adj R-squared 0.0689
Table 5: Results of Sensitivity Analysis 10% Threshold
3 *** indicates that the coefficient is significant at the one per cent level.
Variable Observations Mean Standard Deviation Median Min Max
GAAPETR 492 0.3512 0.0866 .3646 0 0.7571
XCON 492 0.2703 0.4445 0 0 1
LEV 492 0.1827 0.1436 .1792 0 0.6471
SIZE 492 6.2813 0.7150 6.2924 4.3823 9.5648
MARKBOOK 492 2.2252 3.8616 1.9002 -73.5788 17.6199
Shareholder ownership and tax avoidance
25
Consistent with the main finding in section 4.2.1 the coefficient of the dependent variable
XCON is statistically close to 0 with the raised threshold, which means that H0 is not
rejected. This strengthens the earlier finding where there was no effect between the
concentration of ownership and tax avoidance activities. This also holds true when a
concentrated firm is defined as a firm with one or more shareholders with 10% or more of the
total shares.
5.2 Sensitivity analysis – 20% threshold
A different threshold that is used to define a concentrated ownership is the 20% threshold. La
Porta et al. (1999) define a shareholder with 20% of voting rights a controlling shareholder.
Even though voting rights are different from owning shares, voting rights are also used as a
measure for concentration of ownership (Sjögren et al., 2012). Berle & Means define a
controlling shareholder as a shareholder that owns 20% or more of the total shares (1932).
This 20% threshold is a higher measure that is used to define a concentrated ownership
(Sjögren et al., 2012) and testing with this threshold will improve the credibility of the main
findings.
For this sensitivity analysis, I create a new dummy variable as in the previous
sensitivity analysis. I start by changing the dummy variable CONCENTRATED from being
coded as ‘1’ if the firm has one or more shareholders with 5% or more of total shares and as
‘0’ otherwise to being coded as ‘1’ if the firm has one or more shareholders with 20% or more
of total shares and as ‘0’ otherwise. This new variable is called XXCON, where XX stands for
the Roman numeral 20. Table 6 shows the descriptive statistics of the new regression with the
variable XXCON.
Variable Observations Mean Std. Dev. Median Min Max
ETR 492 0.3512 0.0866 .3646 0 0.7571
XXCON 492 0.0813 0.2735 0 0 1
LEV 492 0.1827 0.1436 .1792 0 0.6471
SIZE 492 6.2813 0.7150 6.2924 4.3823 9.5648
MARKBOOK 492 2.2252 3.8616 1.9002 -73.5788 17.6199
Table 6: Descriptive Statistics Sensitivity analysis 20% Threshold
Again, the descriptives of the old variables are unchanged. The new variable XXCON has a
mean of 0.0813, which means that, in this sample, 8,13% of the firms have one or more
Shareholder ownership and tax avoidance
26
shareholders with 20% or more of the total shares. This is significantly lower than the
previous variables and shows that there are not a lot of firms in the sample that own more than
one fifth of a firm.
Table 7 shows the results of the regression between the effective tax rate and the new
variable XXCON.
Coefficient t-value p-value
XXCON -0.0083 -0.59 0.557
LEV 0.1088***4
3.98 0
SIZE 0.00526 0.98 0.329
MARKBOOK 0.0051***
5.1 0
CONSTANT 0.2875***
8.29 0
Observations (N) 492
F-value 10.17
Prob > F 0
R-squared 0.0771
Adj R-squared 0.0695
Table 7: Results of Sensitivity Analysis 20% Threshold
The coefficient for XXCON is still statistically close to 0. This sensitivity analysis also
supports the initial findings. So H0 is not rejected which means that there is no association
between the concentration of ownership and the amount of tax avoiding activities of a firm
when the threshold is set at 20%.
6.0 Conclusion There is a great amount of previous literature on tax avoidance to be found as it is a complex
and rising topic (Hanlon & Heitzman, 2010). However, the amount of studies on tax
avoidance in relation to the concentration of ownership is limited and there still is a call for
empirical evidence on the subject (Desai & Dharmapala, 2008). This research is a reply to that
call for empirical evidence.
This research examines whether the concentration of ownership is associated with tax
avoidance. More specifically, I test whether a high concentration of ownership is associated
4 *** indicates that the coefficient is significant at the one per cent level.
Shareholder ownership and tax avoidance
27
with a change in tax avoiding activities. The measure that is used to determine tax avoiding
activities is the GAAP effective tax rate of a firm. The independent variable, firm
concentration, is a dummy variable which is coded as a '1' for firms with one or more
shareholders with 5% or more of total shares, and as '0' otherwise.
The findings show that there is no association between shareholder concentration and
tax avoiding activities. Thus, the null hypothesis, which stated that there is no association
between the concentration of ownership and the amount of tax avoiding activities, is not
rejected. This contradicts prior literature, which states that a higher concentration of
ownership either results in more tax avoiding activities (Desai & Dharmapala, 2008; Chen et
al., 2009) or less tax avoiding activities (Hanlon & Heitzman, 2010; Chen et al., 2009). The
findings hold up against additional sensitivity analyses, where the threshold of concentration
of ownership was increased to 10% and 20%.
There could be a few reasons why the findings contradict prior literature. The first
reason is that the sample is quite specific and small. The small sample might not be able to
capture all the effects of the entire population and therefore result in a different outcome. A
second reason could be that the measured used for tax avoidance did not take away year-to-
year volatility as it is an annual measure and that it did not capture deferred taxes as tax
avoidance (Dyreng et al., 2008).
There are some limitations to this study. As said earlier, the sample size is small
because of the range restrictions of the Blockholders database. The small sample size could
negatively influence the quality of the findings because a larger sample strengthens the
statistical power of a research. This limitation can be overcome by future researchers by either
choosing a different sample or using a different database that is available to them. There is
another limitation as a result of the range restriction of the Blockholders database. That is the
fact that it is not possible to measure the long-term tax avoidance, as you need data from firms
over a period of at least ten years (Dyreng et al., 2008). By not being able to use this measure
I was not able to take away the year-to-year volatility in annual effective tax rates, which
could have led to qualitatively stronger findings. This limitation can also be overcome by
using a different database that does have the appropriate data available.
This study contributes to the growing stream of literature on tax avoidance as it
answers to the call of empirical evidence. The findings of this study are not in line with prior
literature which means that there still is some ambiguity around the effect of shareholder
concentration on tax avoidance and that this topic should be continued to be researched in the
future. Another contribution that is paper makes, is that it stimulates the discussion about
Shareholder ownership and tax avoidance
28
corporate tax avoidance as an ethical and societal issue. It is argued that corporate tax
avoidance is unethical and that it costs tens of billions of dollars in lost revenue every year to
developing countries (Jones, 2015). This shows that corporate tax avoidance is still a societal
issue and this paper contributes to that discussion by providing additional insights and
bringing up this subject.
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