Corporate social responsibility (CSR) means that a company commits to carry out its business in an ethical way to ensure that there is a positive impact not only on its shareholders but also on its stakeholders, including employees, customers and suppliers, local communities, the environment, and the society at large. In today’s socially conscious environment, more firms have started to adopt CSR as their major corporate strategy and have been integrating social, environmental, and ethical norms into their business operations. According to a report by PwC in 2010, over 80% of U.S. public companies report CSR activities. The growing importance of CSR indicates that the private sector plays a crucial role in addressing social and environmental issues by implementing socially responsible practices.
The rationale motivating the CSR movement is that firms can become more profitable (“doing well”) by engaging in CSR (“doing good”). In this context, numerous studies have identified various factors that can influence firms’ CSR performance. However, studies on how public policies can affect firms’ incentives to engage in CSR activities have, to date, been scarce. This is surprising because public policies center on the efficient delivery of public goods by the public sector and are thus expected to be closely associated with CSR—the private provision of public goods. Our recent working paper fills this gap by investigating the effects of corporate income tax, an important fiscal policy, on firms’ CSR performance.
We develop our main hypothesis based on the effects of corporate income tax on firms’ internal funds and the role of firms’ preference in choosing investment projects. Our first hypothesis postulates a negative impact of corporate income tax on firms’ CSR performance. Compared to conventional corporate investments, such as capital expenditures, CSR investments are more susceptible to adverse selection and moral hazard problems because the investments often involve social goals, have long-term horizons, and can be plagued by agency issues. As such, internal funds are perceived to be more suitable for CSR activities than external funding sources (i.e., debt and equity).[1] We expect that decreases (or increases) in corporate income tax promote (or discourage) firms’ CSR investments through increasing (or decreasing) internal funds available to these firms. In addition, tax changes can have a heterogenous effect on firms’ internal funds. In particular, firms with larger tax exposure and financially more constrained firms are more likely to be affected by tax rate changes. We thus expect the effect of corporate income tax on CSR performance to be stronger for these firms. Another important consideration that leads firms to prioritize CSR investments using their internal funds is the incentives for the firms to behave in a socially responsible manner. These incentives can arise from local pro-social attitudes, shareholders’ ESG preferences, managerial long-term orientation, and product differentiation needs. Thus, we expect these incentives to strengthen the positive effects of corporate tax cuts on CSR performance but attenuate the negative effects of tax increases on CSR performance.
Other economic forces could also shape the relation between corporate income tax and CSR performance. On the one hand, because certain CSR-related expenses are tax-deductible, an increase (or decrease) in corporate tax rates could induce (or disincentivize) firms to exploit the tax-deductibility of CSR-related expenditures to achieve tax shields by strategically increasing the investments in CSR projects. This conjecture yields a positive relation between corporate taxes and CSR investments. On the other hand, CSR projects typically require long-term commitments, and may be difficult to cancel or reverse once the investments have been made. Consequently, firms’ CSR investments are less likely to alter in response to corporate tax changes, which predicts an insignificant relation between corporate tax cuts and firms’ CSR performance. Collectively, various forces can drive the relation between corporate taxes and CSR. The net effect of corporate income tax on CSR performance should reflect the tension among these forces and should be best determined empirically.
Empirical methods
We examine our hypotheses using state-level changes in corporate income tax rates in the U.S. as a quasi-natural experiment. This setting has two advantages. First, the staggered changes of state-level corporate income tax rates are unlikely to be driven by individual firms’ needs to invest in CSR, which helps establish a causal relation between corporate income tax and CSR. Second, given the nonsynchronous timing of tax decreasing and increasing events across different states, we are able to investigate the effects of tax reductions and tax increases on CSR performance separately. We measure firms’ CSR performance using the CSR ratings provided by the Kinder, Lydenberg, and Domini Research & Analytics (KLD) database, which assesses the social, environmental, and governance performance of large public companies in the U.S. Our sample consists of 2,805 U.S. public firms (18,753 firm-year observations) between 1992 and 2016. To examine the effects of corporate income tax on CSR performance, we employ a difference-in-differences approach, where we compare the difference in the changes of CSR performance between firms headquartered in the states experiencing tax changes and those that are not subject to any tax changes.
Findings
We find that compared to firms in the states with no tax changes, firms in the states with tax cuts experience a significant improvement in CSR performance. This finding confirms the hypothesis that firms invest more in CSR projects when internal funds become more available because of lower tax payments. Economically, a tax cut event, on average, leads to an increase in a firm’s CSR ratings by 7.03% relative to the average CSR performance of our sample firms. In addition, we document that in response to tax increases, firms experience an insignificant decline in CSR performance. This result is consistent with irreversible and rigid features of CSR investments, suggesting that the costs of reducing engagement in CSR activities exceed the costs of cutting alternative uses of funds (e.g., capital expenditures or acquisitions). However, the results are inconsistent with the view that firms facing higher marginal tax rates may spend more on CSR activities to enjoy the tax benefits, provided that some CSR-related expenses are tax-deductible.
Examining the cross-sectional heterogeneity in results, we find that the positive effect of tax cuts on CSR is more pronounced when firms face larger financing frictions, e.g., when firms are in higher tax brackets, more financially constrained, or more geographically concentrated in operations, confirming the role of tax reductions in encouraging firms to make CSR investments by alleviating firms’ financial constraints. Moreover, the effects of tax reductions on firms’ CSR ratings vary according to firms’ incentives to be socially responsible. In particular, the effects of tax reductions are more evident in firms headquartered in states where pro-social attitudes are more prevalent, firms having shareholders with stronger ESG preferences, firms with managers being more long-term oriented, and firms operating in more competitive industries. These findings suggest that firms’ desire to increase CSR investments in response to tax cuts is heavily influenced by strong social preferences for ESG. Additional analyses reveal that the stimulating effect of corporate tax cuts on firms’ CSR performance is unlikely to reflect CSR investments as a manifestation of agency problems because the positive relation between tax cuts and CSR performance is not more pronounced for firms with more governance issues.
Furthermore, we show that tax cuts are associated with a significant improvement in quality products, diversity, and employee relations but have insignificant impacts on human rights, environment, and community. The findings suggest that firms use tax savings on CSR activities that are highly relevant to their profits and employees, instead of CSR activities that can have strong externalities (i.e., human rights). Taken together, our results are consistent with the view that tax cuts enable firms to have more internal cash flows for CSR engagement, thereby benefiting their stakeholders.
Finally, we use the Tax Cuts and Jobs Act of 2017, which lowers the federal corporate income tax for all firms, as an out-of-sample analysis. We show that compared to firms with lower prior effective tax rates, firms with higher prior effective tax rates experience an improvement in their CSR performance after the federal tax cut. The results lend further support to our findings using state-level tax changes.[2]
Contributions
Our study contributes to the existing literature in three important ways. First, our findings enrich the literature on the features of CSR investments. Previous literature has identified strong externalities, long horizons, and stickiness as important characteristics of CSR investments. We demonstrate that tax cuts facilitate firms’ socially responsible investments while tax increases do not discourage their CSR investments. In doing so, our analysis complements previous findings by highlighting firms’ dependence on internal cash flows for CSR activities. In addition, we reveal irreversibility as notable attributes of CSR investments. The findings imply that the design of incentive schemes for CSR investments should take these attributes into consideration.
Second, our study contributes to the literature on the effects of corporate income taxes on corporate investments. Recent studies show significant impacts of corporate taxes on firms’ investment decisions, such as capital expenditures, startup activities, corporate innovation, and mergers and acquisitions. We extend this line of literature by focusing on firms’ investments in activities related to social and environmental issues. This is an important addition because non-shareholder stakeholders are vital in determining the success of a business. What is more, understanding the economic policies that can affect the stakeholders’ welfare is essential. Thus, our findings that tax reductions boost CSR investments through increasing internal funds suggest a useful policy focus for policymakers who are interested in cultivating CSR in the economy.
Third, our study joins the debate on the optimal level of corporate taxes. On the one hand, some politicians and policymakers argue in favor of lower tax rates to make firms more profitable and competitive. On the other hand, the opposing view maintains that lowering corporate taxes would further worsen the balance of government budgets and increase inequality. A key issue in the debate is whether lowering corporate taxes can have adverse impacts on long-term economic prosperity and social welfare. Our findings show that lowering corporate income tax can motivate the private sector to provide some public goods that benefit non-shareholder stakeholders, and thus shed light on how to rationalize certain corporate tax systems and understand their economic and social consequences.
Xin Chang is a Professor of Finance and the Associate Dean at Nanyang Business School of Nanyang Technological University.
Yaling Jin is a PhD student at Nanyang Business School of Nanyang Technological University.
Endong Yang is an Assistant Professor of Finance at the Faculty of Business Administration of the University of Macau.
Wenrui Zhang is an Associate Professor of Finance at the Department of Finance of the Chinese University of Hong Kong.
This post is adapted from their paper, “Corporate Taxes and Corporate Social Responsibility”, available on SSRN.
[1] Recent literature has also focused on ESG funds as the major force of socially responsible investment. However, the evidence on whether ESG funds, relative to conventional funds, represent an advantageous choice for firms to fund CSR activities is still mixed.
[2] Anecdote evidence is consistent with the positive effects of tax cuts on CSR. For example, after the Tax Cuts and Jobs Act (signed into law in December 2017), which reduces the federal corporate income tax rate from 35% to 21%, outdoor clothier Patagonia donated the $10 million saved from tax cuts to non-profit environmental groups to raise awareness about climate change. Moreover, the CEO of Boeing, Dennis Muilenburg, stated that Boeing would invest $300 million out of the $480 million tax savings in employee training and education, facility upgrades, and charitable giving.
