Do country risk factors attenuate the effect of taxes on corporate risk-taking?

This study examines whether country-specific risk attenuates the association between tax policies and corporate risk-taking. We define country-specific risk (political and fiscal budget risk) as taxpayer's risk that tax refunds on losses cannot be paid due to the institutional environment or fiscal reasons. We exploit a cross-country panel with 234 changes in corporate tax rates and 49 changes in loss offset rules. We investigate whether government risk-sharing via loss offset rules and tax rates affects risk-taking conditional on country risk. We also examine whether tax rate changes, that scale the risk-sharing effect, influence the propensity to conduct risky projects in different country-level risk environments. Our results suggest that country-level risk fully attenuates the previously documented association between tax policies and corporate risk-taking. It attenuates both the effectiveness of loss offset rules and tax rate changes on corporate risk-taking. While changes in tax policy are attractive to policymakers because alternative instruments to encourage risk-taking cannot as easily be adjusted, we provide significant evidence that country risk considerably limits policymakers' ability to induce firm risk-taking via changes in tax policies.