Customer Tax Uncertainty and Supplier Investment

Abstract:
This paper examines the effect of customer firms’ tax uncertainty on their supplier firms’ investment decisions. We find that customers’ tax uncertainty, proxied by additions to unrecognized tax benefits (UTBs) from current-year positions, is associated with an increased likelihood of underinvestment and a decreased likelihood of overinvestment by suppliers. This finding implies that customers’ UTB reserves appear to increase suppliers’ uncertainty about investment payoffs, thereby increasing (decreasing) their tendency to underinvest (overinvest). We further document that the relation between customers’ tax uncertainty and suppliers’ likelihood of under- or overinvestment is more pronounced for durable goods suppliers, customers with large trade credit, and customers with high financial constraints. These results suggest that when supplier firms are more exposed to risks from customers’ businesses, they are likely more cautious about risks associated with their customers’ tax uncertainty, leading to more conservative investment behavior. Overall, our paper provides evidence on the relevance of UTB information to one of the important stakeholders of the firm, i.e., suppliers.