Tax avoidance as an unintended consequence of environmental regulation: Evidence from the EU ETS

This paper examines the extent to which polluting firms covered by the world's largest multinational emission trading scheme – the European Union Emission Trading Scheme (EU ETS) – engage in corporate tax avoidance. We exploit the sudden and significant increase in carbon prices after decisions made by the EU Council on February 28th 2017, and test whether firms' tax avoidance behavior subsequently changes. We find that pollution intensive firms engage in more corporate tax avoidance after this sudden price shock. This tax avoidance response is economically sizable as the difference between the effective tax rates between the least and most polluting firms is 5.13 percentage points. Supplemental tests indicate that the tax avoidance response of the more pollution intensive firms is dependent on their operating cost structure, while we find no significant difference in the corporate tax avoidance response depending on their financing needs. Moreover, we find some evidence of reputational concerns moderating this relationship. Additional analyses also demonstrate that increased internal and external monitoring, as reflected by higher regulatory quality and board independence, mitigates the corporate tax avoidance response. Overall, our findings are consistent with the notion that firms transfer carbon costs on to governments under the form of lower societal contributions whereas more internal and external monitoring plays a vital role in preventing this transference.