Abstract:

Using a quasi-natural experiment in the form of 113 staggered changes in corporate income tax rates across U.S. states, we provide causal evidence on how taxes affect corporate risk taking decisions. We find that firms respond to tax increases by reducing risk-taking but do not change risk in response to tax cuts. These results are consistent with the theory that the imposition of income taxes reduces the compensation per unit of risk-taking, and thus firms reduce the riskiness of their assets to achieve a new optimal risk-return tradeoff. Further investigation reveals that the results are largely driven by firms with a low ability to offset losses against profits. Our research contributes to the literature on how taxes affect corporate decisions.