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Faculty Insights

Product Market Power and Tax Avoidance

By Wisconsin School of Business

November 21, 2014

Tax authorities continue to target high-profile market leaders like Apple, General Electric, Google, Starbucks, and Amazon in the popular press and in governmental proceedings, accusing these companies of engaging in tax avoidance that costs governments billions of dollars in lost tax revenue. A common attribute among these firms is their powerful influence in their respective product markets. My colleagues Thomas Kubick of the University of Kansas, Michael Mayberry of the University of Florida, Thomas Omer of the University of Nebraska-Lincoln, and I studied how firms’ product market power influences their tax avoidance strategies.

Dan Lynch

Firms regularly compete with one another to capture consumer market share and maximize profits, and a primary dimension of competition is a firm’s product market. While nearly every firm is exposed to some level of competition, some firms are able to influence the price, quality, and nature of the product in the marketplace to a greater extent than competitors, an ability that is referred to as product market power. Firms with greater product market power have a natural hedge against adverse outcomes, allowing them to pursue riskier endeavors with less concern about negative outcomes than their competitors. For example, firms with greater product market power are able to engage in potentially risky behaviors, such as holding less cash, paying more dividends and maintaining higher leverage. Similar to these behaviors, tax avoidance is inherently risky, so product market power should reduce concerns over unsuccessful tax avoidance, because the cost of unsuccessful avoidance activities is less likely to attenuate their ability to maintain their competitive position

My colleagues and I conjectured that product market power offers firms some degree of insulation from competitive threats and therefore provides broader opportunities and potentially greater incentives for firms to engage in tax avoidance. Product market power also allows firms to maintain higher, smoother and more persistent profitability. Prior research suggests that firms with smooth or persistent earnings, such as those firms that possess higher degrees of product market power, are better able to forecast and realize the benefits of tax avoidance. Product market power, therefore, provides a natural hedge against economic shocks, allowing for insulation from predation threats and more persistent profits, which would support greater tax avoidance by product market leading firms. Consistent with these predictions, we use financial statement data from firms during the 1993-2010 time period to document a positive association between product market power and tax avoidance, suggesting that product market power leads to greater incentives and/or opportunities for firms to engage in tax avoidance.

To further examine the impact of product market power on tax avoidance, we explored how product market leaders’ tax avoidance activities influence the tax avoidance outcomes of non-product market leading firms, as well as the consequences for investors. First, we considered whether product market leaders’ success in product markets provides incentives for other firms to mimic the tax avoidance behaviors of product market leaders in order to maintain their competitive positions. Second, we examined how the association between product market power and tax avoidance is valued by investors to determine the ultimate impact of these activities on firm value.

We found evidence that prevailing competitive forces in a product market result in competing firms moving towards the industry-average tax avoidance, suggesting this is the primary benchmark employed. However, after controlling for the mimicking of the industry-average tax avoidance, we found that firms also mimic the product market power leaders’ tax avoidance outcomes. In other words, market leaders’ tax avoidance impacts other firms’ tax avoidance activities.
Finally, we found that investors view the comparatively higher cash tax avoidance of firms with greater product market power as relatively more risky and are less willing to hold these shares than firms with comparatively lower cash tax avoidance, thereby resulting in less informative share prices and higher subsequent stock returns.

In conclusion, product market power provides firms with comparative advantages through more persistent profitability and insulation from competitive threats—advantages that provide firms with the ability to engage in greater tax avoidance. In addition, firms mimic the tax outcomes of their product market leaders. Among firms with greater product market power and comparatively high cash tax avoidance, stock prices are less informative, and investors require additional compensation for the risks associated with comparatively high cash tax avoidance. Overall, our results suggest that industry dynamics, particularly related to a firm’s competitive position, play a meaningful role in corporate tax policy.