Stronger corporate governance reduces diversion of corporate resources and increases the incentive to engage in tax avoidance. However, if diversion and tax avoidance are complementary as argued in prior studies, reducing diversion will have a negative effect on tax avoidance. To investigate which of the two opposite effects prevails, we use an exogenous shock on corporate governance in China and find robust evidence that stronger governance increases the overall level of tax avoidance. The increase is greater when controlling shareholders own more shares and when diversion is less complementary to tax avoidance. In addition, the increase in tax avoidance is driven by legal tax shelters. Data suggest diversion is complementary mainly to tax evasion, and stronger governance does not increase tax evasion. These findings help reconcile/explain the mixed evidence on the relation between governance and tax avoidance documented in prior studies.

JEL Classification: G30; G32; G34; G38; H26
Key Words: Corporate governance; corporate tax avoidance; agency costs; diversion; corporate tax fraud.