Climate risk and corporate tax avoidance: International evidence

• Published date: 01 March 2022
• Author: Yingzhao Ni,Zhian Chen,Donghui Li,Shijie Yang
• Date: 01 March 2022
• DOI: http://doi.org/10.1111/corg.12398

ORIGINAL ARTICLE

Climate risk and corporate tax avoidance: International

evidence

Yingzhao Ni

1

| Zhian Chen

2

| Donghui Li

3

| Shijie Yang

4,5

1

School of Management, Jinan University,

Guangzhou, China

2

UNSW Business School, The University of

New South Wales, Sydney, New South Wales,

Australia

3

College of Economics, Shenzhen University,

Shenzhen, China

4

School of Management and Economics,

Chinese University of Hong Kong, Shenzhen,

China

5

Shenzhen Finance Institute, Chinese

University of Hong Kong, Shenzhen, China

Correspondence

Donghui Li, College of Economics, Shenzhen

University, Guangdong 518060, China.

Email: lidonghui2019@hotmail.com

Funding information

National Natural Science Foundation of China,

Grant/Award Number: 71873058

Abstract

Research Question/Issue: This study investigates the relationship between climate

risk and corporate tax avoidance. Previous studies on this relationship generate

mixed results, theoretically and empirically. Our study addresses this empirical ques-

tion by providing new evidence using a large international sample and a novel proxy

for climate risk.

Research Findings/Insights: The empirical results show that higher climate risk is

associated with higher tax avoidance. Mechanism analyses show that this positive

association is due to the incentive to reserve cash in response to tightened financial

constraints, rather than tax deductions granted by governments. This result is more

pronounced in countries or regions that have poorer corporate governance and

information environments, lower economic development, and a more uncertain

policy environment.

Theoretical/Academic Implications: Our evidence highlights the importance of con-

sidering the role of climate risk in corporate tax policies and of comparing the link

between climate risk and tax avoidance across countries.

Practitioner/Policy Implications: Echoing environmental non-governmental organiza-

tions' (NGOs) recent call on governments to strengthen tax administration, our study

has policy implications that emphasize the necessity for policymakers to consider the

link between climate risk and tax avoidance.

KEYWORDS

corporate governance, climate risk, extreme weather, tax avoidance, financial constraints

1|INTRODUCTION

Extreme weather causes great damage to property and livelihoods,

and it has seriously disrupted firms' production and operation activi-

ties. In 2019, at least 15 separate extreme weather events caused

more than $1 billion in damage, and seven of them caused damage of

more than $10 billion.

1

Climate risks influence countries and regions

and play an important role in firm performance. For example, higher

climate risk leads to lower and more volatile earnings and cash flows

(Huang et al., 2018). However, few studies provide firm-level

evidence on the actions that firms take in response to climate risk. As

tax avoidance is one way in which a firm could retain resources, it

may mitigate the negative effect of climate risk on cash flows; as such,

firms are expected to change their tax policies in response to climate

risk. Climate change is a global issue with large variations across

countries and regions, and by exploring international data, our study

provides novel evidence regarding the relationship between climate

risk and tax avoidance.

The relationship between climate risk and tax avoidance has

attracted public attention in recent years. For example, a report in The

Guardian called on firms to reduce tax avoidance to allow govern-

ments to allocate more resources for dealing with climate disasters.

2

Some non-governmental organizations (NGOs, e.g., Friends of the

Earth International) have argued that corporate tax avoidance

Received: 12 November 2020 Revised: 2 July 2021 Accepted: 7 July 2021

DOI: 10.1111/corg.12398

Corp Govern Int Rev. 2022;30:189–211. wileyonlinelibrary.com/journal/corg © 2021 John Wiley & Sons Ltd 189

prevents governments from implementing policies intended to combat

climate change and called on governments to strengthen tax regula-

tions.

3

These anecdotes highlight the government's role in resource

allocation in response to climate change and that tax avoidance

weakens this important role.

While the relationship between climate risk and firm performance

is unambiguous, it is less clear how climate risk affects corporate tax

avoidance. Theoretically, climate risk may affect marginal benefits and

marginal costs of tax avoidance. On the one hand, since climate risk

leads to less earnings and cash flows (Huang et al., 2018) and greater

investor risk aversion (Kamstra et al., 2003), firms need to hold more

resources in response to lower cash flows and tighter financial

constraints. This indicates a higher marginal benefit of tax avoidance.

In this sense, higher climate risk may correlate with more aggressive

tax avoidance. On the other hand, the reputation cost of tax avoid-

ance activities may be accentuated when climate risk is high because

investors are intolerant to excessive tax planning aggressiveness

during periods when the local economy is affected by climate disas-

ters. Furthermore, tax avoidance may damage a firm's relationship

with the government (Liu et al., 2017). Therefore, the marginal cost of

tax avoidance also increases. To the extent that firms may care more

about climate change and view paying taxes as a way to make contri-

butions to the community, higher climate risk is possibly correlated

with lower tax avoidance.

Empirically, while a few prior studies have examined how

weather and natural events affect corporate tax policies, their

findings are inconclusive. Using data from the United States, Chen

et al. (2019) examine the impact of managerial mood due to weather

conditions on tax avoidance and show that weather-induced mood

increases tax avoidance, as explained by higher subjective percep-

tions of firms' financial constraints. Using Chinese data, Liu et al.

(2017) document that natural disasters (i.e., typhoons) promote less

tax avoidance in Chinese companies, which is explained by the

notion that firms tend to maintain relationships with the government

to obtain governmental benefits (such as grants and credit resources)

in the future. One limitation of prior studies is that they use a single-

country sample, the findings from which might not be generalizable

to other countries.

As discussed above, previous studies on the relationship

between climate risk and tax avoidance provide mixed results, theo-

retically and empirically. Our study addresses this empirical question

by providing novel evidence from a larger international sample. One

empirical challenge is that climate risk is difficult to measure. Climate

risk refers to the risk arising from climate change and affects the

safety of human life and property. Climate change can be divided

into slow-onset processes and extreme weather events. In our

setting, we do not use measures that capture slow-onset processes

(e.g., continuous increase in temperature), because such changes are

likely endogenously correlated with the changes in tax avoidance

measures in the long run. To reduce endogeneity, we focus on

extreme weather events to capture climate risk more appropriately.

Moreover, to overcome the limitation of using single-country data,

we use an international setting by measuring time-varying, country-

level climate risk using the Global Climate Risk Index compiled and

published by Germanwatch. Because this measure is calculated based

on extreme weather-related death toll and economic losses, we use

it as the main proxy for the severity of climate risk. The Global Cli-

mate Risk Index captures the extent to which countries (or regions)

are affected by extreme weather-related events and is considered to

capture the risk induced by extreme weather events. One merit of

this index is that it has substantial within-country variations,

suggesting that the climate risk captured by this index is largely

unexpected.

Using an international sample of 30,916 firms across 71 econo-

mies spanning the period 2005–2018, we show that higher climate

risk is associated with higher tax avoidance for an average firm. This

result is obtained after controlling for year, industry, and country fixed

effects, as well as time-varying country-level and firm-level character-

istics (such as profitability). Therefore, the positive association we

observe is unlikely driven by the long-run average level of climate

risk or due to observable country and firm characteristics. As a

validity test, we show that our climate risk measure based on

extreme weather events is associated with firm-level awareness of

climate risk.

To investigate the mechanism, we discuss and analyze two possi-

ble explanations. First, we show that the positive association is stron-

ger among firms that have higher financial constraints. Second, our

results are unchanged after considering possible tax deductions

granted by governments. Therefore, the mechanism analyses indicate

that the observed positive association between climate risk and tax

avoidance is due to the incentive to reserve cash in response to

tightened financial constraints, rather than tax deductions granted by

governments.

Next, we examine whether the observed relationship between cli-

mate risk and tax avoidance varies across countries that have different

institutional environments and economic development. In our cross-

sectional analysis, we find that this positive association between

climate risk and tax avoidance is more pronounced in countries that

have poorer corporate governance and information environments,

lower economic development, and a more uncertain policy environ-

ment. These results suggest that better corporate governance and

information environments, higher economic development, and a

stable policy environment reduce firm's incentive to reserve cash by

avoiding taxes in response to climate risk.

We also conduct several robustness tests to address endogeneity.

First, following prior studies (Huang et al., 2018), we adopt population

density as an instrumental variable for climate risk to estimate a two-

stage least squares (2SLS) regression. Second, to mitigate the concern

that the results are driven by differences in the characteristics of high

and low climate risk groups, we construct a propensity-score-matched

sample based on firm-level and country-level control variables and

rerun the baseline regression. Finally, we apply Heckman's two-stage

model to address selection bias. All the results show that climate risk

is positively and significantly associated with higher tax avoidance,

which suggests that the observed effect of climate risk on tax

avoidance is unlikely driven by endogeneity problems.

190 NI ET AL.