Corporate Tax Cuts, Merger Activity and Shareholder Wealth

M&A Drivers

A study by Eliezer Fich, Trustee Professor of Finance at Drexel University’s LeBow College of Business, and coauthors, shows that modest cuts in the corporate income tax rate are associated with increased M&A activity, more cash-financed acquisitions, stronger returns, and greater synergies from the deal.

Key Insights

• The modest reduction in the effective corporate income tax rate introduced by the Domestic Production Activities Deduction (DPAD) for work and goods made in the U.S. has had a substantial impact on both the quantity and the quality of mergers and acquisitions.
• A DPAD-induced cut in the effective corporate income tax rate has increased the probability of a company making an M&A bid, the number of bids made, and the total value of M&A deals. This result is especially strong for cash bids and for financially constrained firms who benefit from the DPAD.
• A reduction in the corporate income tax rate triggered by the DPAD has improved the quality of M&A deals by increasing the three-day merger announcement return of the acquirer and by boosting the total synergistic gain from the acquisition. Companies that benefit from the DPAD also pursue M&A targets that are likely to facilitate greater future tax savings.

Summary of Complete Findings

Corporate taxes are likely to influence management decisions as they alter the expected profitability and valuation of investment opportunities. An unexpected windfall of cash caused by an exogenous tax could be associated with the risk that managers with selfish career objectives will use the extra cash to undertake value-reducing investments at the expense of the company’s shareholders. This study shows that such negative decision-making on the part of management does not necessarily happen. Evidence shows that good governance prevails when a corporate tax cut facilitates entry in the market for mergers and acquisitions (M&A), improving the quantity and quality of M&A deals.

The researchers investigated the effects of targeted corporate tax reductions on M&A activity by using Internal Revenue Code Section 199, i.e., the Domestic Production Activities Deduction (DPAD), which was introduced in phases between 2004 and 2010. The DPAD reduces the tax rate on income derived from domestic manufacturing activity by a fixed percentage. As a result, the effective tax rate for a company can range from zero, if it does no domestic manufacturing, to a maximum of 3.15%, if all its manufacturing activity is based in the US.

The sample used by the researchers consisted of 5,072 M&A bids by US incorporated public acquirers announced during 1997-2013 and was tracked in the Securities Data Company’s M&A database. The key variable in the study is the effective tax rate reduction (ETRR), which measures the DPAD-induced percentage reduction in the effective tax rate paid by a company in a given year. The mean ETRR in the sample is 0.25% and the maximum is 3%.

The primary question was whether companies in industries that receive DPAD-related tax cuts engage in more acquisition bids and, in particular, cash bids. The findings show that a higher ETRR leads to a 0.45% increase in the probability of making a bid, a 0.21% increase in the number of bids made and a 1.1% increase in the total M&A deal value.

DPAD has not only increased all bid activity, but it has especially affected cash-financed M&As. In fact, an increase in ETRR leads to a 0.52% increase in the probability of making a cash bid (equivalent to a 29% increase in bid activity) and to a 19.45% increase in the total value of a cash bid.

Financial constraints affect a company’s investment and its M&A activity. This research finds that easing financial constraints through a DPAD-related tax cut has led to even more M&A activity in financially constrained companies than in unconstrained companies. Specifically, an increase in ETRR is associated with a 0.42% increase in the probability of making an all-cash bid and a 1.04% increase (or $6.3 million) in the total cash-deal value for financially constrained companies relative to non-financially constrained companies.

The study also finds that M&A activity by companies that benefit from the DPAD is value enhancing, because the DPAD improves the quality of the deal in terms of bidder returns and acquisition-related synergies. Specifically, an increase in ETRR is associated with a 1.28% increase in the acquirers’ M&A announcement return, and a 0.62% increase in the M&A synergy (defined as the percentage gain to the value-weighted portfolio of target and acquirer at announcement). DPAD companies also tend to pursue targets that are likely to facilitate greater future tax savings. Finally, the findings on deal quality further confirm that financially constrained companies that benefit from the DPAD undertake even higher quality M&A than financially unconstrained companies.

In conclusion, exogenous variations in the effective corporate income tax rate can have a significant impact on M&A activity even when they are relatively modest. The impact is greater for financially constrained firms that usually face more barriers to entry into the M&A market.

“Corporate tax cuts, merger activity, and shareholder wealth” by Jennifer Blouin (University of Pennsylvania), Eliezer Fich (Drexel University), Edward Rice (University of Washington), Anh Tran (City, University of London), was published in the Journal of Accounting and Economics, 2020.
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