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Increasing tax transparency: investor reactions to the country-by-country reporting requirement for EU financial institutions

Abstract

We employ an event study methodology to investigate the capital market reaction to the surprising political decision to adopt a public country-by-country reporting (CbCR) obligation for EU financial institutions. Our results are suggestive of a zero response in our full sample of financial institutions headquartered in the EU. We conduct several sample splits and find that the investor reaction is slightly more negative for banks engaging in selected tax havens and banks with an above-average B2C orientation and slightly more positive for banks with a below-average share of institutional investors. We conclude that investors anticipated a simultaneous reduction in banks’ tax avoidance opportunities and in information asymmetries between managers and shareholders, implying both negative and positive stock price reactions which offset each other on average. We relate our findings to previous studies on the introduction of similar tax transparency measures and contend that capital market reactions to increases in tax transparency depend crucially on the exact design and objective of the initiative. Our inferences are of special importance in light of the ongoing debate whether to enact a general public CbCR obligation for large multinational firms in the EU.

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Notes

  1. 1.

    Tax authority scrutiny should only matter if the tax authority’s prior information set is inferior to the new set after the disclosure requirement is implemented.

  2. 2.

    These studies document a tax semi-elasticity of banks’ overall reported profits of about 2.4 (Merz and Overesch 2016) and of certain trading gains of about 3.4–4.0 (Merz and Overesch 2016; Langenmayr and Reiter 2017). This effect is quite large compared to the consensus estimate by Heckemeyer and Overesch (2017) of 0.8.

  3. 3.

    In particular, we require the price information to be available for at least 80% of the trading days in the event and pre-event period to estimate the expected returns. We keep only banks with a nonzero return in more than 30% of the estimation and event period to capture those firms that are actively traded and thus do not have constant zero returns over time. The sample is very insensitive to any variation of these thresholds.

  4. 4.

    Due to this restriction, we have to drop one bank located in Cyprus and 21 banks located in Italy.

  5. 5.

    Alternatively, we also computed expected returns based on the Stoxx Europe 600 Ex Financials index, which excludes financial firms. The untabulated estimates are very similar to the case when using the S&P Global 1200 index as the benchmark.

  6. 6.

    Strictly speaking, the control group banks may also fall under the scope of Article 89 CRD IV if they have subsidiaries and/or branches in EU countries. Still, in this case, the report covers only the EU entities and their subsidiaries and branches, thus revealing only part of the group structure. This allows groups to structure their operations in such a way that tax haven operations are not evident from the CbCRs of their EU entities. We therefore assume no (or at least a considerably smaller) investor reaction for our control group banks. Besides, we address the issue of the (perceived) scope of the CbCR regulation in the robustness tests in Sect. 5.2.

  7. 7.

    The results based on the Stoxx Europe 600 Ex Financials index yield a negative cumulative average abnormal return of 0.5% with a t-statistic of − 0.613. The results are in general similar to the ones when using the S&P Global 1200 index throughout all further specifications.

  8. 8.

    In response to the financial crisis of 2008, the European Banking Authority has analyzed the exposure of banks to sovereign debt. We use these data, provided by The Guardian Data Blog (2013), to examine the country-specific average exposure of banks to Italian sovereign debt and exclude all jurisdictions in which the exposure to Italy exceeds 10% of the gross exposure to government debt. The results are robust to lowering this threshold.

  9. 9.

    Alternatively, if the effects of the two events are concentrated on the day at which they take place, then they are separable by analyzing the daily average abnormal returns in Table 4 and Panel A and B of Table 5.

  10. 10.

    For her sample split based on tax avoidance incentives, Chen (2017) exploits particularities of the Australian imputation system under which domestic shareholders receive credits for the corporate tax paid by the firm. This identification approach is not suitable in the European Union setting because the countries in our sample generally do not discriminate between domestic and foreign shareholders due to EU regulation.

  11. 11.

    Following Overesch and Wolff (2019), the five selected tax havens are characterized by a low population size and a comparably low GDP. In Table A.6. in Online Appendix, we have included an alternative sample split according to the engagement in tax havens based on the broader tax haven classification of Hines (2010).

  12. 12.

    The reports by Transparency International are based on very large companies and the evidence therefrom may not extrapolate to smaller firms. Kahl and Belkaoui (1981), Lang and Lundholm (1993) and Linsley et al. (2006) provide evidence of a positive relationship between firm size and disclosure adequacy (for banks and non-banks). We hence conclude that smaller banks are no more transparent in their public reporting than larger banks.

  13. 13.

    Murphy (2015), Aubry et al. (2016) and Aubry and Dauphin (2017). Particularly, the analysis of Aubry and Dauphin (2017) for Oxfam received considerable media attention, causing headlines such as “European Banks Stashing Billions in Tax Havens” (EU Observer 2017).

  14. 14.

    For example, Barclays was publicly denounced for maintaining a special “tax avoidance division” (The Guardian 2013b; The Guardian 2013c). As a reaction, the bank voluntarily published a complete CbCR (called “Country Snapshot”) already for financial year 2013. This report (and all following ones) contains several additional tax items and explanations, trying to present Barclays as a responsible taxpayer.

  15. 15.

    The payment items to be disclosed by natural resource companies are production entitlements; taxes; royalties; dividends; signature, discovery and production bonuses; license fees, rental fees, entry fees and other considerations for licenses and/or concessions; and payments for infrastructure improvements.

  16. 16.

    Another potential extension of our study would be to exploit the actual disclosure of banks’ CbCRs as event date(s). However, they are usually published as part of the banks’ annual reports or at least at the same point in time. This makes it difficult to disentangle investor reactions to the CbCR disclosure and to other information published in the annual reports. Hence, we concentrate on different dates in the legislative procedure.

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Acknowledgements

We thank Leslie Robinson, Olli Ropponen, Martin Simmler, two anonymous referees and the participants of the International Institute of Public Finance (IIPF) Annual Congress 2018 in Tampere, the European Economic Association (EEA) Annual Congress 2018 in Cologne, the Annual Conference 2018 of the Verein für Socialpolitik (VfS) in Freiburg and the Mannheim Taxation (MaTax) Science Campus Meeting 2017 in Mannheim for their helpful suggestions and comments. We gratefully acknowledge funding from the MaTax Science Campus and from the Deutsche Forschungsgemeinschaft (DFG, German Research Foundation)—Project ID 403041268—TRR 266.

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Dutt, V.K., Ludwig, C.A., Nicolay, K. et al. Increasing tax transparency: investor reactions to the country-by-country reporting requirement for EU financial institutions. Int Tax Public Finance 26, 1259–1290 (2019). https://doi.org/10.1007/s10797-019-09575-4

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Keywords

  • Tax avoidance
  • Profit shifting
  • Country-by-country reporting
  • Financial institutions
  • Market reaction
  • Event study

JEL Classification

  • H25
  • H26
  • G21
  • G28