Sin taxes face the least political backlash--- intensive lobbying and litigation empirically fail.

In this study, we apply the political cost hypothesis developed by Watts and Zimmerman (1986) to the setting of sin firms. Sin firms are companies producing alcohol, tobacco, gambling, or firearms. This is an excellent setting to examine the role of political costs in influencing firms’ approach to tax avoidance because there are clearly strong societal norms against firms that profit from human vice. Operating contrary to important social norms results in sin firms having greater exposure to additional regulation – an important type of political cost because such regulation may result in wealth transfer from the firm (Bruehne and Jacob, 2019). To be specific, the negative externalities of sin firms’ products on society (e.g., health problems caused to consumers by addictions, second-hand smoking, drunk driving, reduced economic productivity arising from excessive consumptions of cigarette and alcohol) make it more likely that these firms will face additional regulation in an effort to limit these externalities. Due to these negative externalities, there is a significant portion of the public in favor of imposing additional regulations on these firms.1

We examine whether sin firms incur additional costs relative to non-sin firms in the form of higher income tax payments. We expect that the implications for sin firms of being labelled as a “poor corporate citizen” will be much greater among regulators because they face such high exposure to additional regulations on their products. Other things being equal, sin firms lack the political capital (i.e., the influence a firm has with policymakers and regulators) to protect them from regulatory costs stemming from this type of criticism. Clearly, like firms in other industries, sin firms invest heavily in developing political capital and spend significant sums on political contributions and lobbying.2 These political capital investments may help sin firms avoid additional regulations. However, despite these investments, the nature of sin firms’ products and the resulting negative externalities make it much easier for policymakers to impose new taxes and regulations on them without concerns about pushback from their constituents. Therefore, we argue that the negative externalities of their products expose sin firms to much higher baseline levels of risk to additional regulations. Absent the threat of additional regulation, social norms may not affect sin firms’ tax avoidance.

Hong and Kacperczyk (2009) find that sin stocks earn abnormal returns and they attribute the excess returns to investor neglect that occurs because investors stay away from sin firms whose products have a vice nature, and as a result, the level of risk-sharing in those stocks is limited (Merton, 1987). They also find that sin stocks have lower levels of institutional ownership and analyst coverage. Investors’ willingness to ignore stocks with abnormal returns illustrates the power of social norms that work against sin firms. Because sin firms challenge social norms, they face intense scrutiny from politicians and regulators on a number of dimensions. Specifically, sin firms are subject to higher political costs, through the additional regulations imposed on them, such as product market intervention, regulatory intervention in the capital markets, and additional industry specific taxes.

The risk of product market intervention for sin firms is higher than that for most other industries. For example, some restrictions on gun sales (e.g., background checks on firearm purchasers, and prohibition of sales of automatic weapons) have long been in existence in the U.S. The 2006 Unlawful Internet Gambling Enforcement Act (UIGEA) outlawing internet gambling in the U.S. illustrates the power regulatory reform can have on the product market for sin firms. The law specifically bans U.S. banks from handling money related to internet gambling. An article in the Economist notes the act was “hastily tacked onto the end of unrelated legislation” (The Economist, 2011).3 Despite the 10 million Americans participating in online gambling, the article goes on to note that federal legislation to make the industry legal again “has so far got nowhere.” This example illustrates the unusual political cost faced by sin firms. Despite numerous loyal customers, the fact that placing limits on their products is viewed as benefiting society by curbing negative externalities makes it very difficult for these firms to stave off regulation. We expect that managers of sin firms are cognizant of the fact that excessive tax avoidance could be viewed negatively by regulators and policymakers leading to reprisals in the form of additional taxes and regulations. As such, we expect sin firms to be more limited in their ability to avoid taxes than firms in other industries.

Sin firms are also exposed to the risk of regulatory intervention in the capital markets. In fact, consistent with sin firms responding to concerns over regulatory scrutiny, Kim and Venkatachalam (2011) find that sin firms exhibit superior financial reporting quality. They note that “sin firms may be forced to produce higher quality financial reporting to avoid contagion in litigation exposure and heightened regulatory intervention in the capital markets” (p. 422).

Sin firms also have to consider the potential for additional (non-income) taxes to be imposed if they are perceived as being engaged in excessive tax avoidance. Sin taxes are excise taxes levied on goods viewed as harmful to society. Sin taxes are attractive to many policymakers because of the expectation that when you tax something you get less of it. Further, revenue from excise taxes is less volatile than income tax revenue and potentially allows the government to collect revenue from nonresidents. In the U.S., states collected over 32 billion dollars in sin taxes in 2014.4 Sin taxes have a long history in the U.S. including taxes imposed to finance Revolutionary War debts on tobacco, sugar, and distilled spirits (Hines, 2007). Despite criticisms that these taxes are regressive, states have come to rely heavily on revenue from sin taxes as budgets have tightened.

To summarize, sin firms face substantial political costs on a number of dimensions that go beyond the risks posed to non-sin firms. Using the firm-level political risk measure developed by Hassan et al. (2019), we indeed find that sin firms are subject to higher political risk than non-sin firms in our sample.5 Consequently, we expect that managers of these firms will take steps to avoid criticism or scrutiny that could result from significant amounts of tax avoidance. Firms in other industries can rely on job creation, product loyalty, and political connections to help offset the effects of scrutiny over their tax practices. We expect if necessary politicians and regulators will be quicker to act in imposing new taxes and regulations against sin firms because there would be less pushback from the public against regulations or taxes targeted at these firms.