Corporate Taxation and the Cross-Section of Stock

I study the effects of corporate income taxes on a firm’s cost of equity capital. I show theoretically that taxes increase the riskiness of a firm’s after-tax cash flows. The effect arises from the asymmetric treatment of gains and losses in the tax code and applies to both levered and unlevered firms. The main prediction of the model is that firms with lower tax shields have higher expected stock returns. In the data, I use a firm’s average tax rate as a proxy for the size of its tax shields. Consistent with the model, I show that firms that pay high average tax rates have higher expected stock returns than firms with low average tax rates. This finding is a robust feature of the data that is not explained by other firm characteristics or industry effects. ∗The latest version of this paper is available at alexschiller.weebly.com/research. †Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15209, USA. E-mail: [email protected]. I am extremely grateful to the members of my dissertation committee, Brent Glover, Burton Hollifield, Nicolas Petrosky-Nadeau, and Chris Telmer for their invaluable advice and guidance. I also thank Andrew Bird, Lars-Alexander Kuehn, Thomas Ruchti, David Schreindorfer, Chester Spatt, as well as participants of the seminar and macro-finance workshop at Carnegie Mellon Univerisity for valuable comments. All remaining errors are my own.