Trade Liberalization, Financial Flexibility, and Corporate Tax Avoidance

We use import tariff reductions as a natural experiment to explore how trade liberalization causally affects the tax avoidance activities of U.S. firms. Using a Difference-in-Differences matching estimator approach, we find a significant increase in tax avoidance following tariff reductions. The positive effect of trade liberalization on tax evasion is more pronounced in firms that have less financial flexibility prior to the tariff cuts, but is mitigated by corporate governance and other external monitoring mechanisms. Our paper provides initial evidence to highlight the “dark side” and the unintended consequences of trade liberalization in motivating firms to evade more tax, particularly for firms in poor financial positions.