The Strategic Use of Corporate Cash Holdings by Tax Avoiders

Extensive research in corporate finance suggests that strategic consideration determine the level of cash holdings, along with firm characteristics. Empirical findings suggest that the level of cash is positively associated with the risk of predation and systematic future market share gains, obtained at the expense of industry rivals. However, larger cash holdings increase the probability of a strike and weaken the bargaining position in negotiations with labor unions. We propose that that the probability and the amount of tax authority-imposed negative wealth transfers also affects the cash holdings. Since IRS proposed adjustments increase as the excess of book income over taxable income increases and tax-avoiding firms are more likely to be audited by the Internal Revenue Service (IRS), we argue that firms strategically reduce their cash holdings in their efforts to minimize the cost of IRS audits. Our results confirm that firms strategically reduce their cash holdings as the probability of IRS audit and associated costs increase. When the probability of IRS audit increases from 0,10 to 0.40 firms reduce their cash holdings with about 6 cents of a dollar cash reserve. Furthermore, we document that there is an inverse relation between positive excess cash holdings and the probability/cost of IRS audit. We, therefore, suggest that the IRS scrutiny reduces agency problems that positive excess cash can create