McIntire School of Commerce
University of Virginia
This study uses a confidential dataset of firms assigned to the Internal Revenue Service (IRS)’s Coordinated Industry Case (CIC) program to examine the effect of audit certainty on firms’ tax reporting behavior. We first model the determinants of assignment to the program. Though the ability and incentive to avoid taxes are related to CIC assignment, we find that the IRS assigns firms primarily based on size and complexity. We then test whether audit certainty has a detectable effect on tax payments. Our results show that tax payments do not change when firms enter the CIC program, suggesting the CIC program does not have higher deterrence or enforcement effects relative to the IRS’s standard selection and audit process for large corporations not included in the CIC program. However, supplemental analysis suggests that audit certainty does alter managers’ expectations regarding future tax payments. Our paper provides new empirical evidence on the strategic game between the taxpayer and the tax authority and has important implications for tax authorities as they consider the costs and benefits of certain audit programs.
Our study evaluates the role of coordination, at both the government- and the firm- level, on the transfer prices set by U.S. multinational corporations (MNCs) when income taxes and duties cannot be jointly minimized with a single transfer price. We find that either the presence of a coordinated income tax and customs enforcement regime or coordination between the income tax and customs functions alters transfer prices for these firms. Our analyses have implications for both firms and taxing authorities. Specifically, our findings suggest that MNCs might decrease their aggregate tax burdens by increasing coordination within the firm, or that governments might increase their aggregate revenues by improving coordinating enforcement across taxing authorities. Our study is novel in that we document, in a specific setting, how coordination influences MNCs’ tax reporting behavior.
Much empirical evidence is consistent with properly incentivized executives engaging in more tax avoidance. However, other studies provide evidence consistent with tax avoidance facilitating managerial rent extraction. We address these mixed results by reexamining the negative relation between executives’ equity compensation and tax avoidance that is concentrated in firms with weaker shareholder rights. We propose this pattern of results is consistent with tax exhaustion theory because tax benefits from equity compensation reduce firms’ demand for additional tax avoidance. Further, we draw on evidence suggesting shareholder rights indices are problematic as measures of governance when examining tax avoidance. Our results suggest tax exhaustion is a more compelling explanation for the relation between executives’ equity compensation and tax avoidance. Although our analyses do not disprove the notion that managers can use tax avoidance to facilitate rent extraction, they challenge the interpretation of early evidence suggesting this behavior is widespread.
Income shifting from high-tax to low-tax jurisdictions is considered a primary method of reducing worldwide tax burdens of multinational firms. Current losses also affect income-shifting incentives. We extend prior approaches by explicitly considering unprofitable affiliates and test whether the association between losses and tax incentives for unprofitable affiliates deviates from the negative association observed in profitable affiliates. Results suggest that multinational firms alter the distribution of reported profits to take advantage of losses. Our point estimate for profitable affiliates implies that an increase of one standard deviation in the tax incentive, C, of an affiliate with average return on assets of 13.3 is associated with a lower return on assets of 0.5 percentage points. The same change in tax incentive of an unprofitable affiliate is associated with an increase in its return on assets of approximately 0.7 percentage points, holding assets, labor, productivity and other factors constant. We further document a larger responsiveness to tax incentives between profitable and unprofitable affiliates in high-tax jurisdictions, consistent with predictions.
This study investigates the circumstances under which "enhanced relationship" tax compliance programs are mutually beneficial to taxpayers and tax authorities, as well as how these benefits are shared. We develop a model of taxpayer and tax authority behavior inside and outside of an enhanced relationship program. Our model suggests that, despite the adversarial nature of the relationship, an enhanced relationship program is mutually beneficial in many settings. The benefits are due to lower combined government audit and taxpayer compliance costs. These costs are lower because taxpayers are less likely to claim positions with weak support and the government is less likely to challenge positions with strong support inside the program. Further, we show that an increase in the ability of the tax authority to identify uncertain tax positions makes an enhanced relationship tax compliance program more attractive to both the taxpayer and the tax authority.
A firm’s deferred tax position can influence how it is affected by a transition from one tax regime to another. We compile disaggregated deferred tax position data for a sample of large U.S. fi rms between 1993 and 2004 to explore how these positions might affect firm behavior before and after a pre-announced change in the statutory corporate tax rate. Our results suggest that the heterogeneous deferred tax positions of large U.S. corporations create substantial variation in the short-run effects of tax rate changes on reported earnings. Recognizing these divergent incentives is important for understanding the political economy of corporate tax reform.
Can common empirical tests reliably identify tax avoidance? This is an important question because our understanding of the determinants of tax avoidance largely depends on results generated using such tests. We address this question by using a controlled environment to evaluate the relative power of commonly-used empirical tests of tax avoidance. We seed Compustat data with three tax avoidance strategies and examine how reliably empirical tests using different tax avoidance proxies identify this simulated tax avoidance. We find that power varies with the proxy and the type of tax avoidance. Thus, we offer guidance to researchers in matching specific types of tax avoidance with the most powerful test to detect it. We further offer evidence on how research design choices including sample selection and skewness correction affect the power of tests. Results suggest researchers can increase power by eliminating observations with both negative pre-tax book income and negative tax expense, and by using robust regression to address skewness in the data. In contrast, power is impaired when truncating ETR proxies and when estimating tests on small samples.
Our study is motivated by recent FASB proposals for increased current period tax cash flow disclosures to “give users additional information to make predictions about…future cash flows.” These proposals assume tax cash flow is relevant to investors. To test this assertion, we examine how well tax cash flow and tax expense explain both future tax cash flow and variation in contemporaneous stock returns. Our results suggest the incremental predictive power of current period tax cash flow for future tax cash flow is greater on average than that of tax expense. Tax cash flow also dominates tax expense in explaining returns, on average, which further supports tax cash flow as more value relevant than tax expense. However, despite observing a sharp increase in the relative predictive power of current tax cash flow after FIN 48, we find evidence that tax expense is more associated with returns. Our results provide evidence about how investors value firms’ income taxes and suggest the FASB’s proposal for additional taxes paid disclosures – particularly around tax uncertainty - will be useful to investors.
This paper assesses the extent to which the disaggregated book-tax differences (BTDs) detailed in the tax footnote are associated with earnings persistence and growth, and the extent to which these associations matter to investors. Using hand-collected data from the tax footnotes of the Fortune 250 from 1993 to 2007, we find associations between various BTDs and persistence and future growth in earnings. However, we find no evidence that the market prices the BTDs that are associated with earnings persistence and growth differently from other BTDs. The results are consistent with investors ignoring the details in the tax footnote, because the tax footnote is complex, requires accounting and tax expertise, may be obfuscated to protect proprietary information from the taxing authority, and/or is not prominently displayed in the financial statements. This information aids standard setters as they work through the comprehensive review of the income tax accounting model currently underway.
Little empirical evidence exists about the tax rates investors use to forecast future payoffs in valuation models. The limited guidance available suggests investors should use the marginal tax rate (MTR), but it is unclear whether investors follow this guidance. We therefore examine the value relevance of simulated MTRs along with tax rates that are less costly to obtain. Across a battery of tests, we find that a simplified, trichotomous MTR explains firm value better than simulated MTRs, prior-year effective tax rates (ETR), prior three-year average ETRs, or prior-year industry-average ETRs. We find some evidence that the value relevance of other tax rates increases when (1) those rates reflect firm-specific tax benefits not captured by the trichotomous MTR or (2) investors have access to lower cost information that facilitates more complex tax modelling. This study advances the valuation of tax literature and informs management and standard setters of investors’ use of tax information.
We investigate whether intra-firm tax-motivated income distortion affects investment decisions. We model the complex interaction between two affiliates when the tax transfer price is related to an external market price. Our model predicts that increasing tax aggressiveness will lead to greater affiliate investment, but reduced investment efficiency. We use affiliate-level data to develop a firm-specific measure of sensitivity to tax incentives to identify aggressive income-shifting firms. Using this measure, we estimate a positive relation between income-shifting aggressiveness and affiliate investment levels and a negative relation between aggressiveness and affiliate investment efficiency. Our findings empirically test the theory that transfer pricing aggressiveness distorts production decisions. We extend the literature on investment distortions by documenting that global profit maximization can also distort investment levels.
The measured book-tax gap is often used as a surrogate for one of the behaviors that influences the gap—earnings management or tax sheltering—without adjusting for the effect of other influences— GAAP changes, tax law changes, and macroeconomic conditions. This paper provides evidence on the quality of the unadjusted book-tax income gap as a proxy for earnings management or tax sheltering by adjusting for the three measurable factors: GAAP changes, macroeconomic conditions, and earnings management. I find that changes in GAAP alone explain half of the pooled crosssectional variation in the book-tax gap between 1993 and 2004, marking GAAP changes as an important recent influence on the book-tax gap. Also, replication results using unadjusted and adjusted book-tax gap measures suggest that the unadjusted book-tax gap is a reasonable proxy for earnings management, but that adjusting for the effect of GAAP changes generates a better proxy for tax sheltering in most contexts.