Prior research has established the relationship between a change in cash flows and earnings generated by an exogenous shock—an unexpected change in corporate tax policy. The impact of an unexpected change in taxes should be more evident for those companies with better prospects for future profitability. Furthermore, the study argues that the effects of a change in tax policy should have a greater impact on firms with superior corporate governance structures, as better governed companies will more effectively direct the impact on cash flows to shareholders. Results of the study suggest that an interaction between corporate governance and future profitability exists and is most pronounced in smaller sized companies.

Corporate scandals of the past decade, revelations of enormously lucrative compensation schemes, and wildly volatile stock market returns have all played a part in increasing the emphasis on improving corporate governance. Improved corporate governance has been empirically linked to higher firm valuation (Gompers et al., 2003; Bebchuk and Cohen, 2005; Bebchuk et al., 2005; Cremers and Nair, 2005; and Brown and Caylor, 2006). This study examines the relationship between corporate governance and shareholder wealth by investigating the market reaction to an exogenous event, viz., a corporate tax rate change by the Canadian Government in 2005. Although a number of earlier studies have examined the relationship between level of corporate governance and firm value (for example, Gompers et al., 2003), studies incorporating a change in the corporate tax rate in this context are rare. The examination of an exogenous event (such as a tax rate change) and the corresponding market reaction to it provides a unique means to assess the relationship between a firm's corporate governance level and shareholder value.

A change in corporate tax policy is likely to impact a firm's future cash flows and, therefore, affect firm value and shareholder wealth. The study argues that the amount of the increase (decrease) in cash flow as a result of a decrease (increase) in the corporate tax rate that is returned to shareholders may be affected by the level of corporate governance within individual firms. For example, firms with good corporate governance invest (or distribute) most or all of the increase in cash flows for the benefit of shareholders, while firms with poor corporate governance invest (or distribute) less of the increase for the benefit of owners. Unanticipated changes in corporate taxation policy allow one to study how the level of corporate governance in a firm affects the change in shareholder wealth. The corporate tax rate reduction in the 2005 Canadian Federal Budget and its subsequent revocation provide the context for examining the impact of a tax rate change on shareholder wealth.

Applied Finance Journal, Corporate Governance, CG, Corporate Tax, Conventional Governance, Taxation Policy, Canadian Financial Market Research Center, CFMRC, Capital Markets, Abnormal Return, Federal Corporate Tax, Toronto Stock Exchange, TSE, Cash Flow.