Do Country Risk Factors Attenuate the Effect of Tax Loss Incentives on Corporate Risk-Taking?

This study investigates whether tax-specific country risk factors attenuate the effectiveness of tax loss offsets in fostering corporate investments. We posit that impairments of the administrative and financial capacity of countries, administrative risk and budget risk, to provide tax refunds upon losses affect firms’ confidence in tax loss incentives. Exploiting a cross-country panel, we find that country risk factors do damp the effectiveness of loss offsets in fostering risky investments. This effect is economically significant. While the existence of a loss carryback is associated with about 10.1 percent higher corporate risk-taking in low risk countries, we do not find a significant increase in high risk countries. Our results indicate that the damping effect is most pronounced in countries with high administrative risk and high taxes. For loss carryforwards, we document about 3.1 percent higher risk-taking in low risk countries and a less pronounced attenuation under both administrative and budget risk. Additional analyses suggest that the incentive of loss offsets may even reverse under high country risk, especially in high tax countries. Narrower settings around rating downgrades and budget crises provide consistent evidence. Our results suggest that countries’ prompt and reliable processing of tax refunds can be undermined by country risk factors. For tax incentives to succeed, governments need to minimize administrative and budgetary risks.