GOVERNANCE AND TAXES: EVIDENCE FROM REGRESSION DISCONTINUITY *

Andrew Bird and Stephen A. Karolyi

First draft: November 2014

This draft: April 2016

*
All remaining errors are ours. We would like to thank Jennifer Blouin, Craig Cowen, Alan Crane, Alex
Edwards, Todd Gormley, David Guenther, Camille Landais, Ed Maydew (the editor), Sebastien Michenaud,
Suzanne Paquette, Tom Ruchti, two anonymous referees, and participants at the Oxford Centre for Business
Taxation Annual Symposium, the Waterloo Tax Policy Research Symposium and the UNC/Duke Fall Camp for
helpful comments.

Tepper School of Business, Carnegie Mellon University. Address: Posner Hall, 5000 Forbes Ave, Pittsburgh, PA,
USA, 15213. Office: (412) 268-5170. Email: apmb@andrew.cmu.edu, skarolyi@andrew.cmu.edu.
 GOVERNANCE AND TAXES: EVIDENCE FROM REGRESSION DISCONTINUITY

Abstract

We implement a regression discontinuity design to examine the effect of institutional ownership

on tax avoidance. Positive shocks to institutional ownership around Russell index reconstitutions
lead, on average, to significant decreases in effective tax rates (ETRs) and greater use of
international tax planning using tax haven subsidiaries. These effects are smaller for firms with
initially strong governance and high executive equity compensation, suggesting poor governance as
an explanation for the undersheltering puzzle, and appear to come about as a result of improved
managerial incentives and increased monitoring by institutional investors. Furthermore, we
observe the largest decreases among high ETR firms, and increases for low ETR firms, consistent
with institutional ownership pushing firms towards a common level of tax avoidance.

Keywords: tax avoidance, institutional ownership, governance, international tax planning

 I. INTRODUCTION

The governance role of institutional investors has received increased academic attention

in recent years, due to the growth in institutional ownership and the claims of large institutional

investors (Appel, Gormley, and Keim 2015, Cremers, Ferreira, Matos, and Starks 2015, Ferreira

and Matos 2008). Many of these institutional investors make specific claims about their role in

shaping corporate tax strategy. 1 What remains unclear, however, are the objectives institutional

investors intend to meet by changing corporate tax policy, how they meet these objectives, and,

quantitatively speaking, how much they are actually able to change corporate tax choices.

Through improved corporate governance, increased institutional ownership should lead to

better alignment of the incentives of managers and shareholders, and so also to a level of tax

avoidance that is closer to the preferred choice from the perspective of shareholders. Whether

this results in an increase or a decrease in effective tax rates (ETRs) depends on whether the

initial level of investment in tax avoidance activities is too high or too low. Weisbach 2002

argues that the significant benefits of using tax shelters combined with the low probability of

getting caught yield an undersheltering puzzle. However, the extant empirical literature on this

topic, particularly as it concerns corporate governance and tax avoidance, is mixed (Armstrong,

Blouin, Jagolinzer, and Larcker 2015).

1
The Blackrock Investment Guidelines discuss several tax issues the possibility of supporting poison pills if they
are put in place to protect tax benefits (such as under Section 382), the tax consequences of employee stock purchase
plans and the presence of excise tax gross up payments as part of golden parachutes. Vanguards proxy voting
guidelines discuss the importance of tax deductibility of bonus plans under Section 162(m). Institutional Shareholder
Services (ISS), in their Summary Proxy Voting Guidelines, talk about tax fees paid to auditors, the importance of tax
benefits when voting on formation of a holding company or to approve a spin-off, and a variety of tax-efficient
compensation issues. We believe that the existence of these tax considerations for issues over which formal
shareholder votes are common suggests that these investors also care about tax choices more generally - this broader
role in shaping tax strategy, and so cross-sectional variation in effective tax rates, is what we investigate empirically
in this paper.

1
 In this paper, we provide new evidence to this debate using a regression discontinuity

approach that compares the tax avoidance behavior of firms at the top of the Russell 2000 index

with those at the bottom of the Russell 1000. The Russell indexes are particularly amenable to a

regression discontinuity approach because index inclusion is based on a ranking by market

capitalization on May 31 of each year. At that date, the top 1000 firms become members of the

Russell 1000, and the following 2000 become members of the Russell 2000. Therefore, close to

the threshold, inclusion in each index is quasi-random with respect to corporate behavior.

Because the indexes are value-weighted, the largest firms in the Russell 2000 receive weights

which are 10-15 times larger than do the smallest firms in the Russell 1000, even though they are

similar in size (Chang, Hong, and Liskovich 2015). Whereas we use the Russell 1000/2000

threshold to study the tax preferences of institutional investors, other recent papers have used this

threshold to analyze the price effects of index reconstitutions (Chang et al. 2015), the monitoring

effects of index portfolio weights (Fich, Harford, and Tran 2015), the market liquidity effects of

index reconstitutions (Boone and White 2015), the institutional ownership impact on payout

(Crane, Michenaud, and Weston 2015), the quantity and quality of corporate disclosures (Bird

and Karolyi 2016), and CEO compensation (Mullins 2014), as well as the effect of passive

investors on governance characteristics (Appel et al. 2015). 2 Like Appel et al. 2015, we provide

evidence that apparently passive investors actively affect corporate choices in our case,

corporate tax strategy. 3

2
Some of these papers exclusively investigate the effect of quasi-index investors, which they define using the
investor classifications in Bushee 2001, available on Brian Bushees website
http://acct.wharton.upenn.edu/faculty/bushee/IIvars.html#tqd. In particular, he defines quasi-index investors as those
with low turnover and diversified portfolio holdings.
3
We find similar results to Appel et al. 2015 on quasi-index investors when we use control functions implied by
May 31 closing-price implied market capitalization ranks. Importantly, our main results are statistically robust to
this alternative control function, though the economic significance decreases, consistent with non-passive investors
having an incremental effect on tax rates.

2
Consistent with Crane et al. 2015, we find that, over the period 1996-2006, firms which end up at

the at the top of the Russell 2000 index experience a 10.1% increase in institutional ownership

relative to those at the bottom of the Russell 1000. This exogenous increase in institutional

ownership precedes declines in effective tax rates on the order of two percentage points, or 8-

12%, and is robust to the inclusion of year fixed effects and a broad set of time-varying firm-

level control variables. This corresponds to a $9.35 million decrease in cash taxes paid per year

for the average firm in our sample. We observe this change for both book and cash effective tax

rates. Given the apparently passive nature of most institutional investors, particularly those most

affected by shocks to index inclusion, the economic significance of these effects calls for an

investigation of the underlying mechanisms.

To investigate a potential mechanism through which this tax avoidance is accomplished,

we also investigate the practice of international tax planning through the use of tax haven

subsidiaries. We find that a one percentage point increase in institutional ownership is associated

with a 1.3% increase in the likelihood of having a subsidiary in at least one tax haven country, a

2.2% increase in the number of subsidiaries in tax havens in total, and a 0.6% increase in the

number of distinct tax haven countries in which a firm is active. These results suggest that, on

average, institutional investors encourage international tax planning activities. Because firms

may be unable to execute new international tax planning initiatives quickly, we investigate the

time series properties of the tax haven effect. Consistent with the presence of set-up delays, we

find evidence that the change in both tax haven use and effective tax rates increase in magnitude

over the three years following exogenous changes in institutional ownership. However, our

results suggest that firms are able to adjust tax strategy relatively quickly, including on the

international dimension, which provides a new perspective on the use of tax reporting choices to

3
accomplish earnings management objectives (Dhaliwal, Gleason, and Mills 2004, Krull 2004,

Schrand and Wong 2003, Frank and Rego 2006), which is relevant beyond our institutional

investor context.

If these changes to tax avoidance behavior are indeed the result of changes in

governance, we would expect the magnitude and the direction of the effects to depend on a

firms pre-index inclusion governance and level of tax avoidance. First, the positive shock to

governance should matter most for firms with poor initial governance. We find this to be the case

when measuring governance using the Gompers, Ishii, and Metrick 2003 G-index or the level of

executive equity compensation from Execucomp. When allowing for heterogeneity of the effect

in both of these measures, we find that high governance and high equity incentives both diminish

the change in tax avoidance.

To further explore this governance mechanism, we investigate whether the effect of

institutional ownership on cash and GAAP effective tax rates is associated with changes in

shareholder monitoring and managerial incentives. We proxy for monitoring improvements with

turnover on the board of directors and for changes in managerial incentives with changes in

option compensation. The base effect of institutional ownership on effective tax rates decreases

by approximately half when we include a set of economically and statistically significant

interaction terms between institutional ownership and changes in monitoring and managerial

incentives, which suggests that the change in corporate tax policy arises through increased

governance activities by institutional investors. These governance activities may involve

complex discussions of tax strategy with management or may be as simple as identifying unused

tax credits. 4

4
Cheng, Huang, Li, and Stanfield 2012 relate an example in which this simple form of monitoring would be
beneficial. In 2007, while making its case to PDL Biopharmas board of directors, hedge fund Third Point LLC

4
 One would also expect to see larger increases in tax avoidance for firms with low initial

tax avoidance (high effective tax rates). Allowing the effect of institutional ownership to vary by

the pre-reconstitution quartile of the effective tax rate confirms this intuition. In fact, for firms

with the lowest effective tax rates, being at the top of the Russell 2000 actually results in a

relative increase in GAAP tax rates compared to those at the bottom of the Russell 1000.

Particularly when looking at changes in cash effective tax rates, there is a clear monotonicity in

effect, with firms in the top quartile of effective tax rates seeing decreases on the order of four

percentage points. There is some evidence of a preference of institutional investors for cash over

GAAP tax expense savings in the top and bottom quartiles of the effective tax rate distribution.

This result is consistent with the survey evidence of Graham, Hanlon, Shevlin, and Shroff 2013

that 84% of responding tax executives said that GAAP ETR was at least as important to them as

cash taxes. Hence, larger decreases in cash effective tax rates can be explained by a relatively

more severe undersheltering problem as far as cash savings are concerned, as well as the relative

importance of cashflow to institutional investors. Importantly, these results cannot be explained

solely by mean-reversion in tax avoidance. Because the conditional changes in tax rates we

observe are systematically related to index reconstitutions, the degree of mean reversion must be

different for firms that experience an increase in institutional ownership around index

reconstitutions. In fact, this is exactly why we loosely interpret the result as being consistent with

wrote: [CEO] Mr. McDade readily admitted to us that he has not properly thought through nor effectively
utilized PDLs tax credits, which has and will result in reduced value for PDL shareholders (Third Point LLC vs.
PDL Biopharma 2007). Calling the unused tax credits a readily exploitable Company asset, Third Point identifies
the firms tax strategy as a potential source of value improvement. Although Third Point LLC is a hedge fund
rather than a typical institutional investor, this sort of communication with a companys management and board in
general and the specific suggestion of exploiting unused tax credits are viable actions for any large institutional
investor, particularly because the institutional investors that we study would face even greater frictions than hedge
funds in threatening the firm with potential exit.

5
the existence of some optimal or desired level of tax avoidance on the part of institutional

investors.

These results contribute to our understanding of the determinants of corporate tax

avoidance and suggest that improvements in governance lead to more tax avoidance, especially

through the use of international tax planning strategies. The cross-sectional results based on

differences in ex ante governance and tax avoidance are consistent with institutional ownership

pushing firms toward a common level of tax avoidance and suggest that one of the unintended

consequences of governance-improving reforms will be some convergence of effective tax rates,

and a decline in government tax revenues.

Recent work by Balakrishnan, Blouin and Guay 2014 finds that tax avoidance is

associated with increased information asymmetry, as measured, for example, by analyst forecast

errors. Further, they find that managers appear to attempt to mitigate this asymmetry by

increasing disclosure. In related recent work (Bird and Karolyi 2016), we find that index

reconstitutions are associated with improvements in the quantity and quality of corporate

disclosure. Hence, managers affected by this exogenous shock to governance both increase their

tax avoidance and apparently improve their disclosure enough to offset any associated

information asymmetry.

The extant literature on tax avoidance and governance has, so far, found conflicting

results. Minnick and Noga 2010 find weak evidence that governance is associated with domestic

and foreign tax avoidance, while Khurana and Moser 2012 show that higher ownership by long-

horizon institutional investors is associated with lower tax avoidance, especially for firms with

otherwise poor governance. These results are based on cross-sectional variation in institutional

ownership and so rely on strategies, such as instrumental variables, to disentangle the drivers of

6
corporate tax avoidance and institutional ownership. Desai and Dharmapala 2009 approach this

issue indirectly, by looking at tax avoidance and firm value. They find that tax avoidance

significantly improves firm value only for well governed firms. If one assumes that institutional

investors care about maximizing the market value of the firm, then this result is consistent with

our finding that improved governance leads to increased tax avoidance, with the largest effects

for firms starting out with poor governance. Cheng et al. 2012 find that hedge funds target their

activism efforts toward firms with high tax rates, and effect decreases in tax rates. Relative to

these results on hedge fund activism, our focus on institutional investors provides a setting to (i)

disentangle governance through voice and exit since large institutional investors likely find exit

more costly (especially so if they are indexers) and (ii) investigate a governance mechanism that

is pervasive compared to the much less common case of hedge fund activism and, thus, can

explain a larger fraction of the cross-sectional variation in corporate tax rates.

Armstrong et al. 2015 highlight the importance of considering differential effects of

corporate governance on tax avoidance across the distribution of tax avoidance. They find that

governance, as measured by the financial sophistication and independence of the board, has a

mitigating effect on extreme levels of tax avoidance, with little effect for firms at the mean or

median level of tax avoidance. Our findings, using plausibly exogenous shocks to corporate

governance, illustrate a similar pattern of effects. We also extend these results by elucidating

both the mechanism whereby governance brings about these changes in outcomes, as well as the

nature of tax policy changes underlying the differences in effective tax rates. Relative to both

Armstrong et al. 2015 and Cheng et al. 2012, our setting of Russell index reconstitutions better

isolates the causal effect of institutional ownership on corporate tax policy by eliminating the

possibility of reverse causality (i.e., institutions target firms with poor or improving tax policies),

7
omitted correlated variables (i.e., tax avoidance expertise), and mean reversion in tax avoidance.

Our findings are supported by Chen, Huang, Li, and Shevlin 2015 who focus specifically on the

effect of quasi-index investors (as defined by Bushee 2001) on state and local tax planning in a

similar setting to ours.

Desai and Dharmapala 2006 develop a model to understand the effect of equity

incentives on tax avoidance. The direct effect is that increasing equity incentives causes

managers incentives to become better aligned with shareholders, leading them to increase

cashflow by engaging in tax avoidance. However, rent extraction also falls, and if tax avoidance

and rent extraction are complements, say, because of complexity and monitoring problems, then

tax avoidance will fall. The net effect can in fact be less tax avoidance where governance is poor,

and so the scope for decreased rent extraction is the largest. In fact, this is what Desai and

Dharmapala 2006 find empiricallyincreases in the level of executive equity incentives are

significantly associated with decreased tax avoidance, but only for firms with weak governance. 5

In a similar vein, Chen, Chen, Cheng, and Shevlin 2010 study tax avoidance at family firms and

find that such firms are relatively less tax aggressive; they argue that this is a response to

minority shareholder concerns about the complementarity between rent extraction and complex

tax avoidance. However, there remains some debate about this complementarity in the literature

Blaylock 2015 does not find evidence of a consistent link in a panel of US firms.

Analysts are also known to play an important role in corporate governance (Chen,

Harford and Lin 2015). Chen, Chiu, and Shevlin 2015a show that tax avoidance increases

following declines in analyst coverage associated with broker closures and mergers. 6 This effect

5
Seidman and Stomberg 2015 provide evidence that this negative relation between equity compensation and tax
avoidance is also related to the direct tax benefits of equity compensation. We consider this possibility in Section 4.
6
Allen, Francis, Wu and Zhao 2014 document similar effects using a related strategy.

8
is particularly strong for weakly governed firms and does not appear to be associated with actual

cashflow benefits, suggesting that analysts play a positive role in aligning managers' behavior

with shareholders' objectives. The fact that the significant effects in Chen et al. 2015a mainly

concern reductions in book tax expense is consistent with the primary focus of analysts on

earnings per share, and other book measures, rather than cashflow.

The rest of the paper proceeds as follows: Section 2 describes the data and our empirical

strategy, Section 3 presents the results for the effect of index reconstitutions on tax avoidance,

Section 4 investigates how this effect varies by initial governance and the nature of executives

equity incentives, Section 5 shows how effects vary by the ex ante distribution of effective tax

rates, and Section 6 concludes.

II. DATA AND EMPIRICAL STRATEGY

Data
Our identification strategy relies on variation in institutional ownership due to changes in

the Russell 1000/2000 index membership over time. Two approaches have been used in the

literature to identify these index membership lists. First, because the Russell 1000 and 2000

indexes are explicitly determined by market capitalization rank as of the last trading day in May

each year, the index memberships can be constructed using CRSP data; we use these rankings in

our main specifications. Second, Russell provides index membership data for academic use, and

we use these in robustness checks of our main findings. 7 To be included in the Russell 1000 or

2000 indexes, firms must be resident in the US. 8 In addition, preferred shares, royalty trusts,

7
This alternative does not produce quantitatively different estimates (see Table 7), suggesting that differences in
index membership definitions are not systematically related to the changes in corporate tax policy that we observe.
8
If the country of incorporation and country of headquarters do not match, Russell uses a primary location of assets
test to break the tie.

9
LLCs, limited partnerships, exchange traded funds and mutual funds are excluded. 9 Our data on

institutional holdings come from Spectrum 13-F filings.

As our main measures of tax avoidance behavior, we use effective tax rates, measured

using both book tax expense (GAAP ETR) and cash taxes paid (CASH ETR), following Dyreng,

Hanlon, and Maydew 2010. The benefits to using these effective tax rate measures are that they

are easily observable and salient measures of tax avoidance activity, particularly after including a

rich set of control variables. The main cost is that these rates are not meaningful for firms with

negative pretax income, so that we lose these firms in the main analysis. Such firms have a

weaker incentive to engage in tax avoidance activity, since their only likely benefit would be to

reduce future tax expenses, which may never actually arrive. Hence, our focus in the baseline

results is estimating tax avoidance changes for the majority of firms with positive estimated

taxable income (as proxied by pre-tax book income).

We also consider measures of a firms use of tax havens, along three different margins,

using the subsidiary disclosure in Exhibit 21 of the annual report, as in Dyreng and Lindsey

2009. 10 The simplest is a dummy variable for any disclosed tax haven subsidiaries, and we also

investigate count variables for the distinct number of tax haven subsidiaries, as well as the

number of distinct tax haven countries in which at least one subsidiary is located. These variables

have the benefit of being generally available even for firms with negative income, mitigating the

selection problem associated with the use of effective tax rates, and, in fact, permitting a

comparison of the tax avoidance behavior following index reconstitutions across taxable and

nontaxable firms. In addition, the tax haven variables can potentially illustrate a mechanism

through which a firms effective tax rate is changed.

9
Real estate investment trusts (REITs) are also excluded unless they do not currently, and have not historically,
generated unrelated business taxable income, because such entities cannot be owned by tax-exempt investors.
10
We thank Scott Dyreng for making the subsidiary data available on his website.

10
 Previous literature on the cross-sectional determinants of corporate tax avoidance

documents the empirical importance of including a variety of firm level control variables

(Hanlon and Heitzman 2010). To that end, we include log total assets to account for firm size,

R&D expense, earnings before income, taxes, depreciation and amortization (EBITDA), 11

advertising expense, selling, general and administrative expense (SG&A), year-over-year change

in net sales, capital expenditures, leverage, cash and short-term investments, a dummy variable

equal to one if a firm has any foreign income, intangible assets, gross property, plant and

equipment and a dummy variable equal to one if the firm has any net operating losses. Except for

size, change in sales and the two dummy variables, each of these control variables is scaled by

total assets. We also include a measure of earnings quality from Beatty, Liao, and Weber 2010 to

account for changes in earnings quality due to the change in institutional ownership because of

the presence of earnings in the denominator of the ETR measures. Table 1 shows the summary

statistics for our measures of tax avoidance and these control variables for our main estimation

sample, discussed below.

-----------------------------Table 1 about here-----------------------------

Our sample covers the period 1996 - 2006 and includes 6,603 unique firms. We end our

sample period in 2006 because Russell introduced a policy called banding, which changed their

index assignment methodology in 2007 to reduce switches from one index to another. Banding

poses a challenge to our empirical approach in that it may allow two firms that should swap

places in their respective indexes to remain in their current indexes if the market capitalization

difference is small. In effect, this induces some arbitrary rule in index assignment based on

market capitalization differentials, which would invalidate our regression discontinuity design.

11
We choose to control for EBITDA following Dyreng et al. 2010; replacing this with pre-tax income yields
quantitatively similar results.

11
Empirical Strategy

Our goal is to estimate the effect of an exogenous shock to institutional ownership on

corporate tax avoidance. We rely on the previous literature on Russell 1000 and Russell 2000

membership that provides evidence of a discontinuity in institutional ownership around the index

membership thresholds (Appel et al. 2015, Crane et al. 2015). Russell index membership

satisfies the key aspects of a regression discontinuity design because membership is based on the

May 31 closing-price implied market capitalization rank. Unlike the potential manipulation of

market capitalization, manipulation of the market capitalization rank on the last trading day of

May is inherently infeasible. While the market capitalization rank discontinuities are public

knowledge and consistent through time, the underlying market capitalization thresholds are time-

varying and depend on the cross-sectional distribution of market capitalization at the end of the

May 31 trading day. Firms in the top 1000 market capitalization ranks on that day become

members of the Russell 1000 and the subsequent 2000, those ranked between 1001 and 3000,

comprise the Russell 2000. Therefore, especially close to these market capitalization rank

thresholds, Russell index reconstitutions are quasi-random with respect to corporate tax policy.

That is, firms at the bottom of the Russell 1000 and at the top of the Russell 2000 are similar

except for their Russell index membership determined using their market capitalization rank as

of May 31.

Following Crane et al. 2015, we estimate the following two stage model:

, = + , + =1 , + =1 , , + , + + , (1)

, + 2 , + + ,
, = 0 + 1 (2)

where represents year fixed effects, , is an indicator variable that equals one if firm is a

Russell 2000 index member in year t and zero otherwise, , represents the market capitalization

12
rank of firm in year minus 1,000, , represents the fraction of firm 's shares outstanding

owned by institutions in year , and , represents different measures of tax avoidance, including

GAAP and cash effective tax rates, as well as several measures of tax haven activity.

, (, ) is constructed as annual cash taxes paid (book tax expense) divided

by pre-tax income less extraordinary items in the year of the reconstitution. , includes a set of

time-varying firm characteristics as controls. We include year fixed effects to remove the

possibility that the results are being driven by secular changes in tax avoidance or tax policy. The

parameter represents the order of the polynomial chosen to maximize the Bayesian information

criterion (BIC) as in Lee and Lemieux 2010. Note that an increase in tax avoidance following

Russell 2000 index inclusion will be seen as 1 < 0 when using either effective tax rate as the

dependent variable and 1 > 0 when using the tax haven measures.

It is important that we acknowledge the methodological differences among the other

papers that exploit the Russell index reconstitution setting for identification. In the results

presented here we follow Crane et al. 2015 and impose a -order polynomial control function on

the market capitalization ranks based on May 31 closing prices from CRSP, but, in results

reported in Table 7, we confirm that our main findings hold if we alternatively impose a -order

polynomial control function on Russell index ranks, which include the effects of Russells

proprietary float adjustment. We also confirm that our findings hold if we focus on quasi-indexer

ownership rather than total institutional ownership. In these tests, the economic significance

marginally decreases, but the statistical significance remains, consistent with all types of

institutional investors having an impact on tax policy, not just quasi-index investors.

Another methodological difference among papers that exploit the Russell index

reconstitution is fundamental to the literature on regression discontinuity designs in applied

13
microeconometric research. Rather than implement local linear control functions with bandwidth

restrictions (Hahn, Todd and Van der Klaauw 2001), we follow Lee and Lemieux 2010 and use

an instrumental variables approach that involves polynomial control functions on each side of the

discontinuity in both the first and second stages of estimation. Our choice to follow Lee and

Lemieux 2010 is broadly consistent with the existing literature that uses the Russell setting, and

it reflects the natural tradeoff between statistical power and degrees of freedom in estimation that

is highlighted in the regression discontinuity literature. Because Russell index construction

restricts the number of firms that are ever close to the discontinuity and, thus the statistical

power of tests that impose sample restrictions, we choose the instrumental variables approach

because it provides a means to use variation in institutional ownership and tax avoidance farther

away from the discontinuity to consistently identify the treatment effect of interest without

specifying a bandwidth.

In this setting, observations farther away from the discontinuity will naturally have less

influence on the estimated discontinuities, but they increase the statistical power with which we

estimate the polynomial control functions that identify the discontinuities. It is also important to

note that these polynomial control functions are flexible in nature, because we identify the

polynomial order of best fit using the Akaike Information Criterion and the Bayesian

Information Criterion. 12 This model choice step provides an objective way to trade off

distributional fit with degrees of freedom. Higher order polynomials are able to fit more

inflection points in the empirical distribution, and so allowing the data to identify the optimal

order eliminates the concern that inflection points far away from the threshold are driving the

identification of the discontinuity.

12
These criteria provide a formal method for trading off goodness of fit with the complexity of a statistical model.

14
 Because the variation in regression discontinuity methodology among Russell index

reconstitution papers is meaningful (e.g., Boone and White 2015 use a bandwidth approach), we

also investigate our main results in a bandwidth setting. In Table 7, we present average treatment

effect estimates for a range of bandwidths from 25 firms to 400 firms, all of which yield similar

results to our original methodology. Intuitively, the system of equations (1) and (2) ensures that

the variation in institutional ownership that we use to identify our coefficient of interest, 1,

comes from Russell index reconstitutions. Because the effect of index reconstitutions on tax

policy operates through the institutional ownership channel, we utilize a fuzzy regression

discontinuity design. Technically, the change in tax policy happens stochastically with respect to

the threshold; an observed change in tax policy around the rank threshold does not happen with

certainty, which is the differentiating requirement that a sharp regression discontinuity design

would require.

A fuzzy regression discontinuity design requires a two stage least squares design as in

equations (1) and (2), which means that we can reinterpret the market capitalization ranks and

rank threshold as instrumental variables. Thus, the conditions for instrument validity must be

satisfied. We observe relevance in the top left panel of Figure 1, which plots the discontinuity in

institutional ownership around the rank threshold of 1000. Firms just to the left of the rank

threshold are included in the Russell 1000 and firms just to the right of the threshold are included

in the Russell 2000. Beyond the statistical relevance of the rank threshold, relevance is satisfied

because of two institutional features of the Russell indexes. First, approximately twice as much

institutional investor money is invested in the Russell 2000 compared to the Russell 1000 (Chang

et al. 2015). Second, Russell indexes are value-weighted, meaning that a firm at the bottom of

the Russell 1000 index will have a much lower index weight than a firm at the top of the Russell

15
2000 index. These two features suggest that the discontinuity in institutional ownership around

the May 31 market capitalization rank threshold of 1000 is a result of the Russell index

methodology. Valid instruments must also satisfy the exclusion criterion. In our case, exclusion

is satisfied because other observables are locally continuous at the rank threshold. That is,

inclusion in the Russell 1000 or Russell 2000 will not impact tax policy directly. Rather, its

effect on tax policy exists only because of its effect on institutional ownership.

-----------------------------Figure 1 about here-----------------------------

Because the fuzzy regression discontinuity design is appropriate to our setting, the

smooth local polynomial plots we present in the middle and bottom left panels of Figure 1 are

reduced-form in the sense that they abstract away from the change in institutional ownership at

the rank threshold. In these figures, we can only interpret the jump in tax rates and tax haven use

around the rank threshold as a result of institutional ownership because we also observe the

discontinuity in institutional ownership at the rank threshold, which is shown in the top left panel

of Figure 1, and because of the aforementioned features of the Russell indexes. These two

features suggest that the discontinuity in institutional ownership around the May 31 market

capitalization rank threshold of 1000 is a result of Russell index methodology. Note that the two

stage empirical strategy employed in our formal tests directly connects the firm-level variation in

institutional ownership due to index reconstitutions with changes in tax policy at the same firm.

Also, Figure 1 shows that firms ranked in the bottom half of the Russell 2000 index have lower

institutional ownership than Russell 1000 firms - this points to the importance of the polynomial

control functions that specifically address the nonlinear relationship between market

capitalization and institutional ownership.

16
 Table 2 presents estimates of , from equation (1) in which = 0,1, and 2 for

simplicity. Our evidence is consistent with that of Crane et al. 2015 in that we find strong

evidence of a discontinuity in institutional ownership around the Russell 1000/2000 threshold.

Regardless of , our estimates of the Russell 2000 inclusion effect on institutional ownership at

the Russell 1000/2000 threshold are statistically significant at least at the 5% level. For = 2,

the polynomial form chosen by the BIC, we find that firms at the top of the Russell 2000 index

have a 10.1% increase in institutional ownership relative to those at the bottom of the Russell

1000 index. This 10% increase in institutional ownership is not particularly surprising because (i)

Russell index membership is closely followed by institutional investors, particularly the growing

number of those who benchmark investment performance against one of the Russell indexes, (ii)

the Russell 2000 index has a larger institutional following than the Russell 1000 index (Chang et

al. 2015), and (iii) the value-weighted nature of the Russell indexes, which give much higher

weight to firms at the top of the Russell 2000 index relative to those at the bottom of the Russell

1000 index.

-----------------------------Table 2 about here-----------------------------

This increase in institutional ownership must come at the expense of other shareholder

types. Mullins 2014 provides evidence that other blockholders, including insiders and outsiders,

are not displaced by these new institutional owners, which implies that retail investors, the group

least likely to exert monitoring effort in governance, are the displaced shareholders. Moreover,

Crane et al. 2015 also document a discontinuity in voting participation at the Russell 1000/2000

index threshold, suggesting that these institutional investors are not simply passive stakeholders

from a governance perspective. These results provide causal evidence that Russell 1000 index

membership has an economically large impact on institutional ownership and activity. This

17
evidence complements arguments from Azar, Schmalz, and Tecu 2014 and McCahery, Sautner,

and Starks 2014, which suggest that even small, apparently passive institutions engage in

corporate governance so that even changes in dedicated indexer ownership are likely to impact

corporate policies.

III. INDEX RECONSTITUTIONS AND TAX AVOIDANCE

In this section, we investigate how index reconstitutions, and the consequent increase in

institutional ownership, affect a firms level of tax avoidance, as measured by effective tax rates

and tax haven use.

Cash Effective Tax Rate

To start, we investigate tax avoidance using cash effective tax rates because, at least in the long

run, what should concern shareholders is the cashflow associated with the firm rather than the

reported book income. Real tax avoidance, at least in the long run, results in actual tax savings in

the sense that it results in less cash paid out, rather than changes in the timing or re-labeling of

income streams based on generally accepted accounting principles (Dyreng, Hanlon, and

Maydew 2008). Further, income tax expense can be used as an earnings management device

(Dhaliwal et al. 2004), potentially complicating inference given the possibility of managers

manipulating earnings to increase their chance of being included in indexes. However, for

comparability with other studies and to better understand the objectives of institutional investors,

we also investigate the effect of index reconstitutions on book effective tax rates.

Table 3 presents our baseline results and reveals that, on average, at the 1000/2000

threshold, inclusion in the Russell 2000 index is associated with decreases in effective tax rates

firms increase their tax avoidance. Both with and without a set of time-varying firm controls,

18
cash effective tax rates are significantly lower for firms at the top of the Russell 2000 relative to

those at the bottom of the Russell 1000. 13 Specifically, for a one percentage point increase in

institutional ownership due to inclusion in the Russell 2000 around the threshold, a firms cash

effective tax rate falls by between 0.2 and 0.3 percentage points, which is significant at the one

percent level. Given that the difference in institutional ownership around the 1000/2000

threshold is about ten percentage points, these tax avoidance effects amount to between two and

three percentage points of effective tax rates, or 8-12% of the mean cash effective tax rate in the

sample of 24%. This corresponds to a $9.35 million decrease in cash taxes paid per year for the

average firm in our sample.

-----------------------------Table 3 about here-----------------------------

In principle, rather than an intended goal of institutional investors, these changes in tax

avoidance could be mechanical or indirect consequences of other changes affecting firms around

the time of reconstitutions. In fact, the effect remains statistically significant and its magnitude

falls by about a sixth when control variables are included. This means that other changes

happening at these firms, which may or may not be directly related to tax strategy, account for

part of the effect from (1), but still leave a statistically significant decline. Specifically, this effect

declines to about 0.2 percentage points for a one percentage point increase in institutional

ownership when firm-level controls are included, suggesting that other behavioral changes by

firms are weakly pushing in the direction of increased tax avoidance as well.

13
Because firms are as good as randomly assigned to each side of the threshold, variation in observable and
unobservable characteristics will be balanced across the threshold, rendering controls unnecessary. However, recent
regression discontinuity papers (e.g. Lee and Lemieux 2010) suggest that controls may improve estimation by
decreasing residual variance and thereby increasing estimation efficiency. As a result, we include controls in some
specifications, but because the interpretation of coefficients is much different than in an OLS setting, we omit the
coefficient estimates from the tables to avoid confusion. Additionally, none of the control variables in , are
statistically significant in any of the specifications we present, consistent with the interpretation that they are
balanced across the Russell market capitalization rank threshold.

19
GAAP Effective Tax Rate

We next turn to book effective tax rates. As with cash rates, we find that increases in institutional

ownership associated with Russell 2000 index inclusion around the 1000/2000 threshold are

associated with decreases in tax rates. However, the magnitude and statistical significance of the

changes in GAAP tax rates are lower, with larger standard errors. In the basic specification of

column (3) without firm control variables we do not observe a statistically significant effect.

However, after including these firm controls, we see that an increase in institutional ownership of

one percentage point results in a decrease of GAAP effective tax rates of 0.16 percentage points,

which is statistically significant at the 5% level. This implies that other changes at firms on the

Russell 2000 side of the threshold are leading to higher effective tax rates, partly masking

strategic changes in tax avoidance.

If we compare the results using the GAAP ETR and the cash ETR, we can see that the

cash effect is relatively larger in each specification: without controls across columns (1) and (3),

and with controls across columns (2) and (4). Without controls, this difference is strongly

statistically significant, though the difference becomes insignificant when firm-level controls are

included. These results are consistent with institutional investors prioritizing higher cashflow

over higher reported income, at least on average, and may also reflect a more severe

undersheltering problem for cash rather than book income tax expense. A differential ability to

affect cash taxes paid relative to book tax expense may also be relevant, given that there appear

to be more strategies which reduce cash taxes paid without affecting book tax expense (such as

accelerated depreciation) than the converse. We return to this issue in Section 5.

20
Use of Tax Havens

So far, we have shown that index inclusion is associated with significantly lower effective tax

rates. We next turn to a possible mechanism through which these reductions are accomplished

international tax planning. Since most international tax planning involves the use of subsidiaries

in low tax jurisdictions like tax havens, and subsidiary locations are available from firms annual

reports, we focus on three different measures of firms presence in tax havens. Table 4 presents

the results, with the mean of each tax haven measure in the preceding year included at the bottom

of the table for ease of interpretation.

-----------------------------Table 4 about here-----------------------------

Column (1) shows that a one percentage point increase in institutional ownership causes a

1.27 percentage point increase in the likelihood of a firm having at least one tax haven

subsidiary, an effect that is statistically significant at the 5% level. Including firm controls

increases the effect to 1.32 percentage points, which is also statistically significant at the 5%

level. These results actually understate the magnitude of the effect, since firms which already had

a haven subsidiary cannot respond along this margin; an alternative interpretation is a one

percentage point increase in institutional ownership leads approximately 4% of firms that did not

have a tax haven affiliate to invest in one.

In order to study international tax planning intensity, particularly for the majority of firms

in the sample which already made some use of tax havens prior to index inclusion, we also carry

out our empirical tests using a count of tax haven subsidiaries and a count of distinct tax haven

countries in which the firm is active. Both measures increase following a one percentage point

increase in institutional ownership, with the total number of tax haven subsidiaries rising by

2.2% and the total number of distinct tax haven countries used by 0.6% (for the tests including

21
firm controls). For the average increase in institutional ownership from Russell 2000 inclusion

around the 1000/2000 threshold, these magnitudes correspond to a 22.1% increase in the number

of tax haven subsidiaries and a 5.7% increase in the number of distinct haven countries used.

These results suggest that incremental institutional ownership associated with index inclusion is

associated with increased complexity and intensity of international tax planning, even for those

firms which were already active in tax havens.

These results show that at least some of the change in effective tax rates associated with

index inclusion can be attributed to increases in tax haven activity. Dyreng and Lindsey 2009

find that having material operations in at least one tax haven country is associated with a 1.5

percentage point lower book effective tax rate. This means that the tax haven adjustment along

the extensive margin alone can explain approximately half of the effective tax rate change

through the use of haven tax avoidance strategies. The intensive margin of adjustment through

tax haven subsidiaries and distinct haven countries likely explains some of the remaining effect.

However, we find such a change in effective rate on average across all firms around the

threshold, so that such specific strategies are unlikely to explain the entirety of the effects we

find. Of course, it may also be the case that the firms in our sample are particularly able to

exploit international tax planning relative to the broad sample in Dyreng and Lindsey 2009.

Beyond highlighting a mechanism through which tax avoidance is accomplished, our

three tax haven measures also address the possible selection issue related to effective tax rates

that we require positive estimated taxable income in order to calculate such rates. In the

preceding results, no such sample requirement was necessary. This shows that even including

firms with negative income, and so a possibly mitigated incentive to avoid tax, yields statistically

22
significant effects. 14 It is important to note that these tax haven results may possibly have an

alternative explanation - improved disclosure following increases in institutional ownership.

Specifically, higher institutional ownership may be associated with incentives to increase

transparency (Bird and Karolyi 2016), which could lead to a more thorough and complete listing

of a firms material subsidiaries, including those resident in tax havens. To investigate this

possibility, we look at the timing of the effect, where we expect to see some delay in response, if

in fact real behavior is changing. Table 5 shows how the effect of institutional ownership varies

in the first, second and third years following index reconstitutions for the main effects we have

identified so far-cash ETR and use of tax havens. As expected, the increased tax avoidance,

according to each measure, increases as time passes, given the greater opportunity to adapt tax

strategies to the objectives of institutional owners, though is only statistically significant in a few

of the cases. The fact that there is nonetheless a relatively strong immediate effect on tax strategy

is consistent with prior literature, such as Cheng et al. 2012 and Dyreng et al. 2010, on the timing

of effects of management- and governance-related shocks. Further, there is plentiful evidence on

the use of taxes to manage earnings in order to meet earnings benchmarks (Dhaliwal et al. 2004,

Krull 2004, Schrand and Wong 2003, Frank and Rego 2006); this suggests that at least some

aspects of tax strategy can be changed relatively quickly in response to changes in incentives.

Our tax haven results contribute to this evidence, suggesting that set-up costs and delays to

changing international tax planning may be relatively small.

-----------------------------Table 5 about here-----------------------------

For several other reasons, we expect that the haven results point to at least some actual

change in behavior, even if the subsidiary disclosures are indeed improved following Russell

14
There is nonetheless some incentive for loss firms to set up tax haven subsidiaries to prepare for future profits and
also to engage in more complicated loss shifting strategies, as studied in Klassen, Seidman and de Simone 2014;
however, it may be difficult to observe such strategies without unconsolidated data.

23
2000 membership. First, the changes in cash ETRs discussed above must be coming from some

real behavioral changes by firms, of which the use of international tax planning is a natural

example. We provide further evidence that such planning is happening in Section 3.5, where we

show that decreases in ETRs are relatively larger for multinational firms. Second, international

tax planning activity could respond rapidly by making greater use of existing subsidiaries and

structures. Such a response could lift some existing subsidiaries and haven countries to the level

of materiality, which would then get disclosed in the years immediately following the firm's

change in tax strategy.

Other Mechanisms and Measures

International tax planning is one mechanism by which firms can change their GAAP and

cash effective tax rates, but it is by no means the only potential mechanism. Therefore, in this

section, we address explanations and robustness by exploring alternative measures of tax

aggressiveness previously proposed in the tax literature. We use book-tax differences, or , ,

a residual measure of the book-tax gap, or , , and a tax shelter prediction score, or

, . 15 Additionally, we follow Balakrishnan et al. 2014 by introducing industry-by-year-

adjusted measures of GAAP and cash ETRs to account for unobservable time-varying industry

forces that may impact tax planning. Wilson 2009 provides evidence that , is

significantly associated with actual cases of tax sheltering, and Desai and Dharmapala 2006

argue that their residual measure of the book-tax gap, or , , which is adjusted for total

accruals, is a more precise measure of tax sheltering activity than simple book-tax differences.

1 (, +, )
15
Formally, using Compustat variable codes, we calculate , = [, ]. We calculate
,1 0.35
, as the residual from a regression of , = 1 , + + , , where , equals total accruals scaled by
+
lagged total assets. Finally, we calculate = 4.30 + 6.63 1.72 + 0.66 + 2.26( ) +


1.62 + 1.56( ) , where is an indicator variable that equals one if the company has

any foreign income.

24
Lastly, we include a measure of cash effective tax rates with operating cash flows in the

denominator, rather than book income, because of recent work by Guenther, Krull, and Williams

2014. They show that cash ETRs can be low either because of tax aggressiveness decreasing the

numerator, or the inflation of earnings leading to a higher denominator, and that replacing book

income with operating cash flows effectively removes the latter effect.

The results presented in Table 6 are broadly consistent with the effective tax rate and tax

haven findings. Firms at the top of the Russell 2000 index become more tax aggressive relative

to firms at the bottom of the Russell 1000, on average. These findings suggest that international

tax planning is not the only source of changes in tax rates around index reconstitutions and that

the influx of institutional investors impacts both the permanent and temporary components of

book-tax differences. Results using the operating cash flow version of the cash ETR are in fact

larger relative to their respective mean values than is the regular cash ETR, which is consistent

with the results of Bird and Karolyi 2016 that institutional ownership leads to improved earnings

quality, and thus less earnings manipulation and mechanically higher ETRs. This means that the

cash ETR results from Table 3 are, in practice, biased downwards due to this effect.

-----------------------------Table 6 about here-----------------------------

Robustness

As discussed in Section 2, there are multiple ways to implement a regression

discontinuity design. In this subsection, we consider alternative specifications, placebo tests and

particular control strategies to deal with other potentially confounding differences across firms

around the Russell 1000/2000 threshold.

Table 7 presents a series of methodological robustness checks. The most straightforward

robustness test is to include either industry or firm fixed effects to control for constant,

25
unobservable drivers of tax strategy at either the industry or firm level. In both cases, we obtain

similar effects of institutional ownership on our main dependent variables cash ETR, GAAP

ETR and use of tax havens. Note that the inclusion of firm fixed effects effectively means we get

identification only from firms which actually switched from one Russell index to the other over

the course of our sample, rather than just any firm which was ever close to the threshold. 16 This

marginally increases our standard errors but does not meaningfully affect inference. Next, we try

using an alternative market capitalization ranking of firms based on data from CRSP rather than

that directly provided by Russell, and find similar results, which is unsurprising given the

similarity across the two lists. Appel et al. 2015 restricts attention to only variation in

institutional ownership for quasi-indexers, as defined in Bushee 2001. This strengthens

identification in the sense that variation in ownership by such investors is the most exogenously

driven by index reconstitutions as opposed to other factors. However, when we restrict to

variation in quasi-indexer ownership, we get coefficients with similar magnitudes and statistical

significance, which suggests that substantially all of the variation in institutional ownership

around the threshold has a similar effect on tax policy. For this reason, we are comfortable

including all institutional ownership in our main tests.

-----------------------------Table 7 about here-----------------------------

A more general falsification test is to investigate tax differences around other, arbitrary,

thresholds in market capitalization rankings where we would not expect to find anything

significant. The middle set of results in Table 7 shows estimates using our baseline methodology

16
We do not include fixed effects in our baseline specification for two reasons. First, using quasi-random index
assignment for firms close to the threshold incorporates more variation from which to identify the coefficient on
institutional ownership (i.e., more statistical power). Second, switchers are more likely to be firms that are moving
far across the threshold (e.g. growing quickly), meaning that they are less likely to be randomly assigned.

26
at rankings thresholds of 500, 750, 1,250 and 1,500. We find coefficients which switch signs and

are never close to statistical significance for any of our three main results.

As discussed in Section 2, there is some debate in the econometric literature about the

best way to implement a regression discontinuity design. At the bottom of Table 7, we present

results using a bandwidth methodology with bandwidths of 25, 50, 100, 200 and 400, in contrast

with the polynomial approach of our baseline results. We obtain similar findings, with slightly

larger magnitudes for small windows around the threshold, though with larger standard errors

due to the limited number of firms close to the threshold. As the bandwidth is increased, and so

more firms are included, the magnitude of the institutional ownership effects decrease, while, as

expected, the standard errors also decrease. Even at a bandwidth of 400, our estimates are similar

to the baseline. As the bandwidth increases, the results become closer and closer to a simple

comparison of averages across the Russell 1000 and Russell 2000 indexes, which is one of the

reasons we prefer the polynomial approach which controls for size trends in institutional

ownership.

In Table 8, we consider two specific alternative explanations for our results differences

in performance or differences in multinationality around the threshold. Although we control for

performance using return on assets in our main specification (EBITDA divided by total assets) it

is certainly possible that performance could have a differential effect on tax avoidance on either

side of the threshold or that this simple linear control is insufficient to capture the effects of

performance. To address the former concern, we include separate control functions (i.e.

polynomials) for return on assets on either side of the Russell 1000/2000 threshold. This yields

similar results, with slightly smaller, though not statistically different, effects for GAAP ETR

and haven use; in addition, the control function itself does not show a discontinuity in

27
performance around the threshold. We also investigate an alternative approach to dealing with

potentially non-linear differences in performance around the discontinuity by non-parametrically

controlling for performance using ten buckets of ROA. This allows for performance to flexibly

affect tax avoidance. Again, we find similar results, suggesting that differences in operating

performance are not driving our tax results.

-----------------------------Table 8 about here-----------------------------

The possibility of differences in multinationality around the threshold is an important

concern for both the effective tax rate measures and the haven measures because secular

economic trends in the US versus the rest of the world could lead to an overrepresentation of

multinationals on one side of the threshold or the other. Since it is well known that

multinationals face different tax burdens than domestic-only firms, this overrepresentation could

lead to erroneous conclusions. We address this issue using two different strategies in Table 8.

The first is to implement several alternative strategies to better control for the extent of

multinationality. We add controls for the percentage of a firms sales which are foreign and the

number of foreign subsidiaries and find similar results. Likewise, if we include polynomial

control functions for either of these multinationality measures, the results are unchanged. A

stronger way to exclude differences in multinationality as an explanation for our results is to split

the sample into multinationals and domestic-only firms. The effect of institutional ownership for

multinationals is indeed higher, as would be expected given our tax haven results. However, the

effect on domestic-only firms is still significant (at either the 5% or 10% level, depending on

definition of multinationality), and is itself not typically statistically significantly different from

the effect on multinationals.

28
 IV. EXECUTIVE EQUITY INCENTIVES AND GOVERNANCE

In this section, we investigate whether the effects of index reconstitutions on tax avoidance vary

predictably according to a firms ex ante levels of governance and executive compensation

structure, motivated by the findings of Desai and Dharmapala 2006 and Armstrong et al. 2015.

At the Russell 1000/2000 threshold, the effect of the positive shock to governance from the

increase in institutional ownership following inclusion in the Russell 2000 index should depend

on the firms initial governance position as long as the effect of institutional ownership on

governance is nonlinear. If, as expected, the effect is diminishing in the ex ante level of

governance, then we should see larger effects on tax avoidance from index inclusion for firms

with poor initial governance. Likewise, executive equity incentives should play a similar role in

aligning managerial incentives with those of shareholders and so any tax avoidance effects

should be diminishing in the level of such incentives. Essentially, the undersheltering identified

in Section 3 should be concentrated in firms with poor governance and a lack of equity

incentives. To investigate these hypotheses, we interact the effect of Russell 2000 inclusion-

induced institutional ownership with dummy variables denoting high initial governance, defined

as firms whose Gompers et al. 2003 G-index is below the cross-sectional mean for that year, 17

and high equity incentives, defined as firms whose executive equity compensation is above the

cross-sectional mean for that year. We also alternatively measure governance using the ex ante

level of institutional ownership since it is this measure of governance which is directly affected

in our quasi experiment, and to address the concern that the G-index is mostly associated with

entrenchment rather than aspects of governance having more to do with monitoring and incentive

alignment, which might be more closely connected to a firms tax strategy.

17
We use the five year moving average of the G-index because it is not available all the way through our sample
period, though this variable is highly persistent over time. However, similar results are obtained if we drop firm-
years for which the G-index is not available.

29
 We start by investigating the effect of high equity incentives, to proxy for a high level of

incentive alignment, on tax avoidance, as measured by cash effective tax rates, in column (1) of

Table 9. This shows that the effect of index inclusion for firms with high levels of equity

incentives is essentially zero the entire effect on tax avoidance comes from firms with low

levels of equity incentives. In columns (2) and (3), we instead interact the index inclusion

dummy variable with one of the two good governance measures and find similar results. The

change in tax avoidance for firms with good governance is negative but statistically

indistinguishable from zero so that again, substantially the entire increase in tax avoidance in the

sample is coming from firms with poor pre-inclusion governance.

-----------------------------Table 9 about here-----------------------------

Equity compensation and corporate governance can play similar roles in motivating

managers, as suggested by the results above, so we include all differential effects at once to

investigate how they interact to determine the effect of incremental institutional ownership on

tax avoidance. The results of column (4) show that it is mainly poor governance which leads to

undersheltering. Put differently, poor equity incentives reduce tax avoidance only when

governance is otherwise poor. When governance is good, as measured by either the G-index or

institutional ownership, equity incentives no longer have a significant effect on tax avoidance.

Replicating the above four specifications for the GAAP effective tax rate yields similar

results tax avoidance increases as institutional ownership increases for firms with poor

governance or below average levels of equity incentives. These results show that the average

results from columns (3) and (4) in Table 3 are concealing significant impacts of institutional

ownership on book tax avoidance for a large subset of firms. Note that all of these specifications

30
also include the level of equity incentives to control for the direct tax benefits of equity

compensation (Seidman and Stomberg 2015).

How Does Institutional Ownership Affect Tax Avoidance?

In the preceding sections, we documented evidence that exogenous shocks to institutional

ownership from Russell index reconstitutions led to economically and statistically significant

increases in tax avoidance, as measured by effective tax rates, use of tax havens and book-tax

differences. One question that remains is the mechanism whereby these new institutional owners

actually affect the tax strategy pursued by the firm. Institutional owners use their influence and

votes directly to monitor and, thus affect these strategies, or indirectly by incentivizing the firms

managers to pursue actions consistent with the objectives of the institutional shareholders. We

investigate these two possibilities in Table 10. In column (1), we replicate our main specification

for comparison purposes, since data requirements leave us with a smaller sample size for this set

of tests. This shows a slightly larger effect of institutional ownership on the cash ETR of about

three percentage points for a ten percentage point increase in institutional ownership.

The most obvious and observable way for institutional investors to monitor firms is through the

board of directors. A change in such monitoring behavior should often be associated with

turnover on the board. Hence if increased monitoring is to explain changes in tax avoidance, we

would expect to see larger effects on behavior in cases where index reconstitutions are followed

by some change in the composition of the board of directors. To identify this turnover without

losing any firms from our sample, we make use of firms 8-K filings (Current Report) to the

SEC. Specifically, we code a firm as experiencing board turnover if the firm filed an 8-K

including an Item 6, Resignations of Registrants Directors, (or Item 5.02 under the new

coding system used after 2004), in the year after inclusion in the Russell 2000. In column (2), we

31
interact institutional ownership with this dummy variable and find that the fall in effective tax

rates is significantly greater when the composition of the board of directors has changed, which

suggests that increased or improved monitoring is indeed a mechanism that institutional owners

use to affect tax policy.

-----------------------------Table 10 about here-----------------------------

To investigate the incentive mechanism, in column (3) we add an interaction term

between institutional ownership and the change in the fair value of option awards to the CEO of

firm between years and 1, as a percentage of total assets. The coefficient on this

interaction term enters negatively and is significant at the 10% level, so that firms where

executives got more high-powered equity incentives following the increase in institutional

ownership also undertook a greater increase in tax avoidance. Hence it appears that improved

governance, in this case measured by increased institutional ownership, leads to more tax

avoidance, as a result of both increased monitoring as well as explicit incentive alignment.

However, there is still a negative effect of institutional ownership on the cash effective tax rate in

the absence of these particular strategies (as seen by the significantly negative coefficient on

uninteracted institutional ownership). This is to be expected, since, for example, monitoring

could be increased or improved even under the existing board through interaction between the

new shareholders and the board or managers directly.

In column (4) of Table 10, we include interactions of both director turnover and the

change in options granted to the CEO, as well as with a dummy variable denoting big changes

in option awards (in the top quartile) to allow for a differential effect of the largest changes in

incentives. All three interactions are negative, as expected, though there is obvious

multicollinearity driven by the fact that these are complementary strategies which are likely used

32
simultaneously by institutional investors. That is, monitoring of the firm increases through

changes to the board of directors and this additional monitoring often coincides with, or results

in, changes to managerial incentives. 18 Nonetheless, through these two channels, we are able to

explain about half of the effect of institutional ownership on tax policy, as can be seen by

comparing the coefficients on institutional ownership (in the first row) across columns (1) and

(4). We believe this provides strong evidence that our results indeed reflect the influence of

institutional investors rather than some other correlated, omitted variable associated with index

reconstitutions. In principle, if we were able to perfectly capture more subtle monitoring

mechanisms, or more subtle incentive design choices, such as the decision to calculate bonuses

or equity awards using pre- or post-tax figures, we would expect to be able to explain even more

of the remaining effect.

It is important to note that these findings could reflect either changes in governance

brought about directly by institutional investors as they communicate with boards and

management, or they could reflect the fact that increased institutional ownership eases

coordination among shareholders (Brav, Jiang, Portnoy, and Thomas 2008, Bradley, Brav,

Goldstein, and Jiang 2010). Thus it could be the case that institutional investors act as a powerful

silent partner abetting or strengthening other more obviously active, or even activist, investors.

These other investors may have always wanted the firms tax policy to change but find it easier

to actually accomplish this change after institutional investors replace retail investors. A small

retail investor likely does not have sufficient economic reason or expertise to listen to and

understand the pitch of an active investor in most cases, while the sizable stake held by

18
Note that these regressions also include the level of the director turnover variable as well as the measure of option
compensation, which addresses the possibility that changes in option compensation, or the tax treatment thereof,
lead to mechanical changes in effective tax rates which could undermine our interpretation of the results (Seidman
and Stomberg 2015).

33
institutional investors can justify expending effort to investigate formal or informal proposals by

other shareholders.

V. CROSS-SECTIONAL VARIATION IN TAX AVOIDANCE

One of the key insights of Armstrong et al. 2015 is that the relationship of governance

and tax avoidance varies over the distribution of effective tax rates. Intuitively, governance

should have a mitigating effect on extreme levels of tax avoidance in the sense that improved

governance should lead to increases in particularly low effective tax rates and decreases in

particularly high effective tax rates. Likewise, the magnitude of the change should be largest for

extreme tax rates, since it is likely less costly for a firm to adjust its tax rate back towards the

mean the more extreme it was to start. In fact, this is what Armstrong et al. 2015 find, though

they cannot rule out reverse causality or omitted variables as alternative explanations. In this

section, we use our regression discontinuity approach to investigate this heterogeneity by

allowing the effect of index inclusion to vary based on the quartile of the firms pre-

reconstitution year effective tax rate.

The first two columns of Table 11 implement this strategy for the cash ETR. Strikingly,

the effect of increases in institutional ownership from index inclusion on the tax rate for firms

with the lowest ETRs (i.e. highest level of tax avoidance) turns positive. These are the firms

which are most likely to be overinvesting in tax avoidance, so that new institutional owners will

cause a shift in strategy towards less tax avoidance. That the effect switches signs for firms with

the lowest effective tax rates is reassuring, because it seems plausible, given anecdotal evidence

on the use of tax shelters, that at least some firms are actually below the shareholders preferred

tax rate because of aggressive tax planning. The effects for the other three quartiles are

34
monotonically decreasing, reaching statistically significant declines for the third and fourth

quartiles.

-----------------------------Table 11 about here-----------------------------

Turning to the GAAP ETR in columns (3) and (4), we find a similar monotonicity of

results, with a significantly significant increase in the rate in the bottom quartile leading

monotonically to a large decrease in the rate for the top quartile, of almost three percentage

points on average for a firm on the Russell 2000 side of the 1000/2000 threshold. Overall, these

results, combined with those of Section 4, suggest that institutional ownership compresses the

cross-sectional distribution of tax rates, pushing firms toward a common effective tax rate.

Importantly, these results cannot be explained solely by mean-reversion in tax avoidance.

Because the conditional changes in tax rates we observe are systematically related to index

reconstitutions, the degree of mean reversion must be different for firms that experience an

increase in institutional ownership around index reconstitutions.19 In fact, this is exactly why we

interpret the result as being consistent with the existence of some optimal or desired level of tax

avoidance on the part of institutional investors.

Table 3 documented suggestive but weak evidence for a preference by institutional

investors for cash over book tax savings, consistent with an institutional focus on cashflow.

Comparing the cash and GAAP ETR results in Table 11 provides some additional evidence for

this prioritization. In the top quartile, where presumably the incentive of institutional investors to

adjust the firms tax strategy is highest, there are large, statistically significant differences

19
For example, consider two low ETR firms which are in the Russell 1000 in one period. Suppose one of them
switches to the Russell 2000 in the next period. Our results suggest that the switcher will have a larger increase in
ETR than the firm that remained in the Russell 1000. In particular, this relation holds whether the firm that stays in
the Russell 1000 increases or decreases its ETR. That is, mean reversion in ETRs would predict that both low ETR
firms would increase their ETR in the next period, but our result suggests that the low ETR firm that switches to the
Russell 2000 increases their ETR relative to the low ETR firm that remains in the Russell 1000.

35
between the two sets of results. Cash ETRs decrease much more for the top quartile relative to

the GAAP measure, while this relationship flips for the bottom quartile.

These results fit with the tax haven results from Section 3.3 in the sense that the marginal

reduction in effective tax rates from the increased use of tax havens should be highest for firms

with the highest initial effective tax rates. Incremental use of tax havens almost certainly leads to

cashflow benefits, but only leads to higher reported income if the earnings are designated as

permanently reinvested, thus avoiding any deferred tax charge, which is not always the case.

VI. CONCLUSION

In this paper, we study the link between corporate tax avoidance and institutional

ownership using a regression discontinuity approach which exploits the quasi-random nature of

Russell 1000/2000 index inclusion for firms around the market capitalization threshold. Our

main result is that firms at the top of the Russell 2000 index experience declines in effective tax

rates and increase their use of tax haven subsidiaries relative to those at the bottom of the Russell

1000 index. These increases in tax avoidance are largest for firms with poor ex ante governance

and high initial tax rates, which suggests that increases in institutional ownership push firms

toward a common effective tax rate, and implicate poor governance as an explanation for the

undersheltering puzzle. Institutional investors appear to be particularly concerned with cash

effective tax rates, in contrast with managers and analysts. Further, these results imply that

improvements in corporate governance will lead to increased tax avoidance, declines in tax

revenue and some convergence in effective tax rates.

Future research should seek to better understand the mechanisms through which

shareholders affect corporate tax strategy. We view two particular margins as deserving of

attention. First, we would like to understand the relative contributions of better shareholder

36
coordination and direct governance interventions. Second, and relatedly, future work should

consider whether these tax effects are due to agency conflicts or learning about tax efficient

decisions.

37
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41
 Figure 1. Graphical Evidence of Discontinuities

This figure shows graphical evidence of discontinuities in outcomes around the Russell 1000/2000 threshold. On the
left, starting from the top, are institutional ownership, CASH ETR and GAAP ETR. On the right, starting from the
top, are the tax haven indicator variable, the number of tax haven subsidiaries, and the number of distinct tax haven
countries. Each plot uses a polynomial smoother on either side of the threshold. 95% confidence intervals are
depicted in grey.

42
 Table 1. Summary Statistics

This table provides firm-year level summary statistics for the firms in the Russell 1000 and Russell 2000 indexes
between 1996 and 2006. GIndex is the five-year rolling average of the Gompers et al. 2003 governance index, which
takes values between 0 and 24. EquityCompShare is the proportion of total CEO compensation awarded in the form
of stock or stock options. Executive compensation data come from Execucomp and pertain to the subset of firm that
are in both the S&P 1500 and Russell indexes simultaneously. Other firm characteristics are scaled by total assets
except for Size, which is measured by lnTotalAssets, Sales, which is the year-over-year change in net sales, and
AnyForeign and NetOperatingLoss, which are both indicator variables. AnyForeign equals one if the firm has any
foreign income and zero otherwise, and NetOperatingLoss equals one if the firm has any tax loss carryforwards and
zero otherwise. GAAPETR and CASHETR are constructed as either total tax expense or cash taxes paid divided by
pre-tax income less extraordinary items, and data on tax havens come from Dyreng and Lindsey 2009. TaxHaven is
an indicator variable that equals one if the firm has at least one tax haven subsidiary and zero otherwise.

Mean SD 25% Median 75%

Tax Variables:
GAAP ETR 27.46% 17.84% 15.28% 30.04% 36.58%
CASH ETR 23.98% 22.42% 6.62% 20.61% 33.43%
TaxHaven 61.31% - - - -

Firm Characteristics:
IO 65.18% 21.64% 48.68% 66.70% 82.37%
GIndex 9.08 2.68 7 9 11
EquityCompShare 40.41% 2.28% 38.65% 40.26% 41.73%
Size 7.42 0.98 6.46 7.43 8.18
R&D 0.1346 2.0937 0 0 0.0254
EBITDA 13.63% 16.08% 6.56% 12.27% 19.64%
Advertising 1.06% 2.92% 0 0 0.88%
SG&A 20.96% 18.01% 6.63% 17.84% 31.80%
Sales 0.1988 1.2598 -0.0036 0.0913 0.2361
CAPEX 13.08% 10.91% 6.34% 9.72% 16.89%
Leverage 23.97% 21.12% 6.54% 21.92% 35.16%
Cash 15.42% 17.51% 2.68% 8.56% 22.24%
AnyForeign 47.71% - - - -
IntangibleAssets 17.48% 19.44% 1.72% 9.51% 28.31%
GrossPP&E 39.87% 28.58% 14.76% 32.92% 64.12%
NetOperatingLoss 42.21% - - - -

43
 Table 2. Institutional Ownership Around the Russell 1000/2000 Threshold

This table provides regression discontinuity of the effect of Russell 2000 index membership on the fraction of shares
outstanding owned by institutions, or , , between 1996 and 2006. Specifically, we estimate , = + , +

=1 , + =1 , , + , + + , and present estimates in which we vary k, the order of the
polynomial. Columns (1) and (2) present estimates for k=0, columns (3) and (4) present estimates for k=1, and
columns (5) and (6) present estimates for k=2. , includes log total assets, R&D expense, earnings before income,
taxes, depreciation and amortization (EBITDA), advertising expense, selling, general and administrative expense
(SG&A), year-over-year change in net sales, capital expenditures, leverage, cash and short-term investments,
earnings quality (based on Beatty et al. 2010), an indicator variable for foreign income, intangible assets, gross
property, plant and equipment and an indicator variables for net operating losses. Except for size, change in sales
and the two dummy variables, each of these control variables is scaled by total assets.

,
k=0 k=1 k=2
(1) (2) (3) (4) (5) (6)

, 0.089** 0.080* 0.108** 0.113*** 0.106** 0.101**

(0.043) (0.042) (0.054) (0.051) (0.042) (0.041)

, NO YES NO YES NO YES

Year FE YES YES YES YES YES YES
2 0.1917 0.1930 0.2078 0.2102 0.2422 0.2439
Observations 22,374
***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

44
 Table 3. Baseline Results

This table provides regression discontinuity estimates of the effect of institutional ownership on effective tax rates
between 1996 and 2006. , is the fraction of shares outstanding owned by institutions, instrumented by Russell
2000 index membership as in Table 2. , estimates are presented in columns (1) and (2), and ,
estimates are presented in columns (3) and (4). , (, ) is constructed as annual cash taxes paid
(book tax expense) divided by pre-tax income less extraordinary items. A two sample t-test of difference between
column (1) and column (3) has a p-value of 0.0071 and a two sample t-test of difference between column (2) and
column (4) has a p-value of 0.1303. The Cragg-Donald Wald F-statistic ranges from 39.17 to 48.62 depending on
the specification, but all values exceed the Stock-Yogo weak instrument thresholds. The Anderson LM statistic p-
values are less than 0.01 in all specifications. , includes log total assets, R&D expense, earnings before income,
taxes, depreciation and amortization (EBITDA), advertising expense, selling, general and administrative expense
(SG&A), year-over-year change in net sales, capital expenditures, leverage, cash and short-term investments,
earnings quality (based on Beatty et al. 2010), an indicator variable for foreign income, intangible assets, gross
property, plant and equipment and an indicator variables for net operating losses. Except for size, change in sales
and the two dummy variables, each of these control variables is scaled by total assets.

CASH ETR GAAP ETR

(1) (2) (3) (4)
,
-0.237** -0.205*** -0.137 -0.168**
(0.091) (0.074) (0.088) (0.075)

, NO YES NO YES
Year FE YES YES YES YES
2 0.5320 0.5402 0.6860 0.6928
Observations 15,214 15,368
***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

45
 Table 4. Tax Havens as a Mechanism for Tax Avoidance

This table provides regression discontinuity estimates of the effect of institutional ownership on effective tax rates
between 1996 and 2006. , is the fraction of shares outstanding owned by institutions, instrumented by Russell
2000 index membership as in Table 2. , is an indicator variable that equals one if firm i has at least one
tax haven presence in year t and zero otherwise, and both and are
log-transformed. Data on tax havens come from Dyreng and Lindsey 2009. The Cragg-Donald Wald F-statistic
ranges from 25.06 to 72.45, all of which exceed the Stock-Yogo weak instrument thresholds. The Anderson LM
statistic p-values are less than 0.01 in all specifications. , includes log total assets, R&D expense, earnings before
income, taxes, depreciation and amortization (EBITDA), advertising expense, selling, general and administrative
expense (SG&A), year-over-year change in net sales, capital expenditures, leverage, cash and short-term
investments, earnings quality (based on Beatty et al. 2010), an indicator variable for foreign income, intangible
assets, gross property, plant and equipment and an indicator variables for net operating losses. Except for size,
change in sales and the two dummy variables, each of these control variables is scaled by total assets.

TaxHaven HavenSubsidiaries HavenCountryPresence

(1) (2) (3) (4) (5) (6)
,
1.265** 1.322** 2.319*** 2.206*** 0.509*** 0.565***
(0.601) (0.546) (0.735) (0.694) (0.175) (0.158)

, NO YES NO YES NO YES

Year FE YES YES YES YES YES YES
2 0.4862 0.4877 0.1159 0.1178 0.2238 0.2253
[,1 ] 67.72% 36.33% 2.68
Observations 22,374
***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

46
 Table 5. Delayed Tax Haven Use and Tax Rate Effects

This table provides regression discontinuity estimates of the effect of institutional ownership on effective tax rates
and tax haven use between 1996 and 2006. Columns (1) and (2) present cash and GAAP effective tax rate evidence,
and columns (3)-(5) present tax haven evidence as in Table 4. , is constructed as annual cash taxes paid
divided by pre-tax income less extraordinary items. Data on tax havens come from Dyreng and Lindsey 2009. The
Cragg-Donald Wald F-statistics exceed their Stock-Yogo weak instruments thresholds in all specifications. The
Anderson LM statistic p-values are less than 0.01 in all specifications.

CASH ETR TaxHaven HavenSubsidiaries HavenCountryPresence

t -0.205*** 1.322** 2.206*** 0.565***

(0.074) (0.546) (0.694) (0.158)
t+1 -0.254** 1.246* 2.346** 0.649***
(0.112) (0.688) (0.741) (0.196)
t+2 -0.282* 1.466* 2.390** 0.715**
(0.151) (0.869) (1.202) (0.265)
***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

47
 Table 6. Alternative Tax Measures

This table provides regression discontinuity estimates of the effect of institutional ownership on tax avoidance
between 1996 and 2006. , is the fraction of shares outstanding owned by institutions, instrumented by Russell
2000 index membership as in Table 2. , is constructed as in Rego and Wilson 2012, , is constructed
using the linear model estimated in Wilson 2009, , is constructed as in Desai and Dharmapala 2008, and
, and , are effective tax rates adjusted by industry as in Balakrishnan et al. 2014.
, uses operating cashflows in the denominator, following Guenther et al. 2014. The Cragg-Donald
Wald F-statistic ranges from 30.11 to 38.52, but all values exceed the Stock-Yogo weak instrument thresholds. The
Anderson LM statistic p-values are less than 0.01 in all specifications. , includes log total assets, R&D expense,
earnings before income, taxes, depreciation and amortization (EBITDA), advertising expense, selling, general and
administrative expense (SG&A), year-over-year change in net sales, capital expenditures, leverage, cash and short-
term investments, earnings quality (based on Beatty et al. 2010), an indicator variable for foreign income, intangible
assets, gross property, plant and equipment and an indicator variables for net operating losses. Except for size,
change in sales and the two dummy variables, each of these control variables is scaled by total assets.

BTD Shelter TS Adj. CASH Adj. GAAP CASH ETR

ETR ETR OCF
(1) (2) (3) (4) (3) (4)
,
0.303** 0.361** 0.288* -0.264** -0.131 -0.327**
(0.134) (0.194) (0.153) (0.120) (0.088) (0.159)

, NO YES NO YES NO YES

Year FE YES YES YES YES YES YES
2 0.4102 0.5617 0.3943 0.5121 0.6433 0.6256
Observations 15,214 15,214 15,214 15,214 15,214 13,992
***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

48
 Table 7. Specification Robustness

This table provides regression discontinuity estimates of the effect of institutional ownership on effective tax rates
and tax haven use between 1996 and 2006. Column headings represent the dependent variable from the second stage
model, and row headings represent the robustness test. , (, ) is constructed as annual cash
taxes paid (book tax expense) divided by pre-tax income less extraordinary items. Data on tax havens come from
Dyreng and Lindsey 2009. The Cragg-Donald Wald F-statistics exceed their Stock-Yogo weak instruments
thresholds in all specifications. The Anderson LM statistic p-values are less than 0.01 in all specifications. Standard
errors are presented in parentheses.

CASH ETR GAAP ETR HavenCountryPresence

Baseline -0.205*** (0.074) -0.168** (0.075) 0.565*** (0.158)

Industry FE -0.203*** (0.073) -0.166** (0.074) 0.480*** (0.152)

Firm FE -0.196** (0.084) -0.148* (0.081) 0.381** (0.176)
Alternative ranking -0.177** (0.076) -0.153** (0.076) 0.476*** (0.156)
Quasi-indexers only -0.152** (0.069) -0.126* (0.067) 0.415*** (0.149)

Placebo Thresholds:
500 0.030 (0.102) 0.022 (0.113) -0.018 (0.169)
750 -0.068 (0.089) -0.037 (0.091) 0.043 (0.161)
1,250 -0.074 (0.076) -0.081 (0.079) 0.126 (0.142)
1,500 0.009 (0.071) 0.013 (0.074) -0.057 (0.126)

Bandwidth ():
=25 -0.244 (0.140) -0.195 (0.137) 0.722* (0.394)
=50 -0.223* (0.129) -0.181* (0.102) 0.638* (0.387)
=100 -0.177** (0.078) -0.143* (0.081) 0.475** (0.231)
=200 -0.155** (0.074) -0.127** (0.058) 0.422** (0.208)
=400 -0.212*** (0.068) -0.184*** (0.055) 0.533*** (0.164)
***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

49
 Table 8. Multinationality and Performance Robustness

This table provides regression discontinuity estimates of the effect of institutional ownership on effective tax rates
and tax haven use between 1996 and 2006. Column headings represent the dependent variable from the second stage
model, and row headings represent the robustness test. , (, ) is constructed as annual cash
taxes paid (book tax expense) divided by pre-tax income less extraordinary items. Data on tax havens come from
Dyreng and Lindsey 2009. Data on foreign revenue come from the Compustat Segments file. The Cragg-Donald
Wald F-statistics exceed their Stock-Yogo weak instruments thresholds in all specifications. The Anderson LM
statistic p-values are less than 0.01 in all specifications. Standard errors are presented in parentheses.

CASH ETR GAAP ETR HavenCountryPresence

Baseline -0.205*** (0.074) -0.168** (0.075) 0.565*** (0.158)

Performance Controls:
ROA control function -0.198*** (0.072) -0.136* (0.073) 0.423*** (0.153)
ROA control bins -0.192*** (0.072) -0.142* (0.072) 0.442*** (0.155)

Placebo Thresholds:
Foreign sales (%) -0.191*** (0.073) -0.148* (0.075) 0.512*** (0.157)
Control function -0.182*** (0.071) -0.133* (0.072) 0.430*** (0.154)
#foreign subsidiaries -0.199*** (0.074) -0.153* (0.074) 0.496*** (0.158)
Control function -0.174** (0.070) -0.151* (0.073) 0.447*** (0.152)

Multinationality splits:
Foreign only (forinc 0) -0.241*** (0.081) -0.206** (0.083) - -
Dom. only (forinc = 0) -0.132* (0.077) -0.097* (0.076) - -
Dom. only (forsubs = 0) -0.166** (0.075) -0.120* (0.074) - -
Dom. only (forsales = 0) -0.158* (0.082) -0.113* (0.075) - -
Dom. only (forsales < 10%) -0.172** (0.076) -0.136* (0.074) - -
***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

50
 Table 9. Executive Equity Incentives, Governance and Tax Avoidance

This table provides regression discontinuity estimates of the effect of institutional ownership on effective tax rates
between 1996 and 2006. , is the fraction of shares outstanding owned by institutions, instrumented by Russell
2000 index membership as in Table 2. Columns (1)-(4) and columns (5)-(8) present cash and GAAP effective tax
rate estimates, respectively. Columns (1) and (5) present evidence on the relationship between CEO equity
compensation and effective tax rates, columns (2) and (6) present evidence on the relationship between corporate
governance and effective tax rates, columns (3) and (7) present evidence on the relationship between ex ante
institutional ownership and effective tax rates and columns (4) and (8) simultaneously include all three interactions.
, (, ) is constructed as annual cash taxes paid (book tax expense) divided by pre-tax income
less extraordinary items. ,1 is an indicator that equals one if ,1 of the
CEO of firm i is above the cross-sectional mean in quarter t-1 and zero otherwise, , is an
indicator that equals one if , is below the cross-sectional mean in quarter t and zero otherwise, and
, is an indicator that equals one if , is above the cross-sectional mean in quarter t and zero otherwise.
The Cragg-Donald Wald F-statistic ranges from 26.34 to 29.41. The Anderson LM statistic p-values are less than
0.01 in all specifications. , includes log total assets, R&D expense, earnings before income, taxes, depreciation
and amortization (EBITDA), advertising expense, selling, general and administrative expense (SG&A), year-over-
year change in net sales, capital expenditures, leverage, cash and short-term investments, earnings quality (based on
Beatty et al. 2010), an indicator variable for foreign income, intangible assets, gross property, plant and equipment
and an indicator variables for net operating losses. Except for size, change in sales and the two dummy variables,
each of these control variables is scaled by total assets.

CASH ETR GAAP ETR

(1) (2) (3) (4) (5) (6) (7) (8)
,
-0.216*** -0.248*** -0.235*** -0.271*** -0.174** -0.181** -0.182** -0.179**
(0.075) (0.082) (0.087) (0.076) (0.077) (0.079) (0.073) (0.071)

, , 0.081* 0.070 0.109* 0.058
(0.046) (0.048) (0.061) (0.059)

, , 0.195* 0.103 0.149** 0.131*
(0.116) (0.087) (0.063) (0.068)

,
, 0.164*** 0.194*** 0.160** 0.155**
(0.065) (0.072) (0.071) (0.072)

, YES YES YES YES YES YES YES YES

Year FE YES YES YES YES YES YES YES YES
2 0.5421 0.5418 0.5422 0.5425 0.6935 0.6933 0.6941 0.6942
Observations 9,956 10,241

***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

51
 Table 10. Governance Mechanism: Executive Turnover and Option Awards

This table provides regression discontinuity estimates of the effect of institutional ownership on cash effective tax
rates between 1996 and 2006. , is the fraction of shares outstanding owned by institutions, instrumented by
Russell 2000 index membership as in Table 2. Column (1) replicates the baseline specification for the effect of
institutional ownership on cash ETRs for this sample, Column (2) presents evidence on the interactive effect of
institutional ownership and director turnover, Column (3) presents evidence on the interactive effect of institutional
ownership and executive option awards, and Column (4) includes interactions of institutional ownership with
director turnover, change in option awards and a dummy variable for big option award changes, defined below.
, (, ) is constructed as annual cash taxes paid (book tax expense) divided by pre-tax income
less extraordinary items. , is an indicator that equals one if firm i files an Item 5.02 (Item 6
before 2004) as part of 8-K filings with the SEC in year t and zero otherwise. , is the change in
option awards to the CEO of firm i between years t and t-1 as a percentage of total assets. 1[,] is an
indicator equal to one if , is in the top quartile of its distribution and zero otherwise. The Cragg-
Donald Wald F-statistic exceeds the Stock-Yogo weak instruments thresholds in all specifications and the Anderson
LM statistic p-values are less than 0.01 in all specifications. , includes log total assets, R&D expense, earnings
before income, taxes, depreciation and amortization (EBITDA), advertising expense, selling, general and
administrative expense (SG&A), year-over-year change in net sales, capital expenditures, leverage, cash and short-
term investments, earnings quality (based on Beatty et al. 2010), an indicator variable for foreign income, intangible
assets, gross property, plant and equipment and an indicator variables for net operating losses. Except for size,
change in sales and the two dummy variables, each of these control variables is scaled by total assets.

CASH ETR
(1) (2) (3) (4)
,
-0.311*** -0.196** -0.190*** -0.154*
(0.092) (0.081) (0.084) (.078)

, ,
-0.152** -0.115*
(0.069) (0.066)

, ,
-0.267* -0.099
(0.141) (0.071)

, 1[ -0.102**
, ]
(0.047)

, YES YES YES YES

Year FE YES YES YES YES
2 0.5410 0.5419 0.5414 0.5422
Observations 9,956
***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

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 Table 11. Ex Ante Effective Tax Rates and the Effect of Institutional Ownership

This table provides regression discontinuity estimates of the effect of institutional ownership on effective tax rates
between 1996 and 2006. , is the fraction of shares outstanding owned by institutions, instrumented by Russell
2000 index membership as in Table 2. Columns (1) and (2) present cash effective tax rate evidence, and columns (3)
and (4) present GAAP effective tax rate evidence. 1,1 , 2,1 , 3,1 , and 4,1 are
indicator variables that equal one if firm i is in quartile 1, 2, 3, or 4, respectively, of the cross-sectional distribution
of effective tax rates before each index reconstitution. , (, ) is constructed as annual cash
taxes paid (book tax expense) divided by pre-tax income less extraordinary items. The Cragg-Donald Wald F-
statistic ranges from 17.12 to 19.49. The Anderson LM statistic p-values are less than 0.01 in all specifications.
, includes log total assets, R&D expense, earnings before income, taxes, depreciation and amortization
(EBITDA), advertising expense, selling, general and administrative expense (SG&A), year-over-year change in net
sales, capital expenditures, leverage, cash and short-term investments, earnings quality (based on Beatty et al. 2010),
an indicator variable for foreign income, intangible assets, gross property, plant and equipment and an indicator
variables for net operating losses. Except for size, change in sales and the two dummy variables, each of these
control variables is scaled by total assets.

CASH ETR GAAP ETR T-test p-value

(1) (2) (3) (4) (2) vs. (4)
,1
, 1 -0.058 0.013 0.152*** 0.137** 0.031**
(0.073) (0.057) (0.056) (0.055)
,1
, 2 -0.037 0.010 0.087* 0.053 0.415
(0.042) (0.061) (0.054) (0.049)
,1
, 3 -0.221*** -0.233*** -0.218** -0.203** 0.602
(0.085) (0.084) (0.089) (0.086)
,1
, 4 -0.597*** -0.476*** -0.354*** -0.363*** 0.016**
(0.113) (0.106) (0.097) (0.097)

, NO YES NO YES
Year FE YES YES YES YES
2 0.5462 0.5467 0.6991 0.6994
Observations 15,214 15,368
***,**,* represent statistical significance at the 1%, 5%, and 10% levels, respectively.
Standard errors are clustered at firm level.

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