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Article Excerpt
INTRODUCTION
The influence of taxes on corporations has largely been considered within a framework where taxes are involuntary payments that influence financing and investment choices on the margin. Such a framework does not dismiss the role of taxes but views them as inescapable environmental factors that must be weighed against a variety of other factors, such as those emphasized in the Modigliani and Miller (1958) framework for understanding corporate financing decisions. Consequently, most scholarly attention has been focused on how taxes change capital structure, dividend or investment decisions. Is the characterization of corporate taxes as an unavoidable burden consistent with contemporary practice?
Accounts of rising corporate tax avoidance suggest that a pure compliance function no longer characterizes the way corporations and managers consider their corporate tax obligation. U.S. Treasury department officials have characterized corporate tax avoidance as "what may be the most serious compliance issue threatening the American tax system today." (1) Such assessments typically point to aggregate measures of tax avoidance including measures of the growing difference between income reported to tax authorities and capital markets, declining effective tax rates on public financial statements and the growing share of firms with no tax liability. For example, Yin (2003) reports effective tax rate reductions in the S&P 500 from an average of 28.9 percent in 1995 to 24.2 percent in 2000 and GAO (2004) reports that 32.7 percent of large U.S. corporations reported no tax liability in 1995 and that percentage rose to 45.3 percent by 2000.
These trends raise a variety of important issues for scholars and policymakers. For scholars, a basic question is: has corporate tax avoidance become more prevalent and, if so, why? A related set of questions for practitioners and policymakers can then be addressed: how should investors and policymakers view efforts to reduce corporate tax obligations? Should managers be rewarded for such efforts? And how should the financial reporting environment facing managers be adapted to these new realities?
The accounts of rising corporate tax avoidance have led some scholars to reframe these questions in an even more provocative way. Given low levels of detection and penalties, why don't all firms avoid corporate taxes? In other words, why are firms paying taxes at all given the likelihood that they could reduce or eliminate tax obligations without suffering significant consequences? This somewhat more cynical set of questions, as posed by Weisbach (2002a), raises even more puzzles about how managers and firms view corporate tax obligations.
This paper attempts to address these questions by reviewing recent research on the prevalence and determinants of corporate tax avoidance. This recent research embeds corporate tax avoidance decisions within an agency framework that emphasizes managerial motivations. In doing so, this research attempts to analyze the determinants of firm heterogeneity in undertaking corporate tax avoidance. Such a research agenda requires defining corporate tax avoidance, devising a measure of corporate tax avoidance, and then analyzing what determines variation in firm choices about tax avoidance. The results point towards a variety of factors that run counter to the typical characterizations of why firms engage in tax avoidance. Specifically, they suggest that opportunistic managers can employ the technologies of tax avoidance to advance managerial, rather than shareholder, interests.
Before going any further, it is worth emphasizing that defining corporate tax avoidance is non-trivial. Many scholars suggest that corporate tax avoidance activities--or the use of corporate tax shelters, a largely synonymous term--are most effectively defined by what they are not. Many corporate transactions--including the most elemental financing choice of whether to finance oneself with debt rather than equity--have important, but typically secondary, tax consequences. Such decisions are primarily motivated by an underlying business purpose. Thus, even though they may generate tax benefits, they are not typically considered instances of corporate tax avoidance. This intuition for how to define corporate tax avoidance has become established in tax law through the "economic substance," "business purpose," and other "anti-avoidance" doctrines (e.g., Weisbach, 2002b). Such doctrines create exceptions to the otherwise applicable tax law in order to deny tax deductions generated by activities that are deemed to be purely or primarily motivated by tax avoidance. As with obscenity, though, the most functional definition of corporate tax avoidance may be a somewhat more facetious one. Michael Graetz has defined tax shelters as transactions that are "done by very smart people that, absent tax considerations, would be very stupid." (2)
In the following, we follow this tradition by emphasizing transactions that have no purpose other than tax avoidance.
We begin by discussing how corporate tax avoidance decisions can be embedded within a broader agency framework. Specifically, we show that managers can use tax shelters to pursue their own interests rather than shareholder interests. In order to clarify the intuition behind this alternative view of corporate tax avoidance, we dissect a real corporate tax shelter and distill its lessons to develop a simple stylized example. These examples illuminate how corporate tax avoidance activities need not advance the interests of shareholders. Then, we outline a method for measuring tax avoidance and discuss large-sample results on the determinants of corporate tax avoidance decisions. These results indicate that corporate tax avoidance decisions are not merely transfers from the state to the shareholders. Finally, we discuss what the implications of these findings are for the financial reporting standards to which managers should be forced to adhere and, in particular, for the question of whether requiring book-tax conformity would be desirable. We conclude with some implications for managers, scholars, and policymakers.
MANAGERIAL MOTIVATIONS FOR CORPORATE TAX AVOIDANCE
Why do firms engage in tax avoidance? A simple and prevalent view in existing research is that tax shelters represent a means of reducing tax obligations and little more. As such, these investigations frame the use of tax shelters within the literature on non-debt tax shields (as in DeAngelo and Masulis (1980)), as one of many transactions that can reduce taxes. Graham and Tucker (2006), for example, estimate the degree to which tax shelters substitute for debt as a means of reducing tax obligations. This framework, however, minimizes the distinctive nature of tax shelters--that they serve no economic purpose other than tax avoidance--and abstracts from any notion of managerial motivations that might not be aligned with shareholder interests.
A first pass at incorporating managerial motivations into an analysis of corporate tax avoidance suggests that managers with interests more closely aligned with those of shareholders would behave more like residual claimants and engage in tax avoidance more aggressively to advance the interests of their shareholders. Within this framework, the historic unwillingness of managers to engage in corporate tax avoidance can be explained as a reflection of a principal-agent problem that put a natural brake on corporate tax avoidance, as agents were unwilling to pursue actions that advanced shareholder interests. (3) This intuition has the added benefit of tying together the rise of incentive compensation and increased levels of corporate tax avoidance over the last 15 years. Essentially, shareholders want managers to avoid taxes, and managers, once their incentives are sufficiently aligned, engage in tax avoidance.
This view, however, does not incorporate all the dimensions of the central tension between managers and shareholders. In addition to shirking, managers may behave opportunistically in other ways that are not in the interests of shareholders. How could this opportunism be related to tax avoidance? A critical dimension of corporate tax avoidance is the need to engage in actions that obscure the underlying intent of the transaction. Indeed, tax avoidance usually demands such obfuscation to guarantee the tax benefits. Such obfuscation, however, can simultaneously provide a shield for managers engaging in a variety of diversionary activities. As such, the technologies of diversion--managers engaging in actions not in the interests of shareholders-and sheltering--managers shielding income from tax authorities--may well be complementary. Specifically, engaging in sheltering may reduce the marginal costs of diverting income. As discussed below, such an interpretation of corporate tax avoidance appears to be consistent with anecdotal and systematic evidence provided in recent research.
This complementarity can be modeled in a variety of ways. In Desai, Dyck, and Zingales (2007) this complementarity is portrayed as an interaction between resources diverted by managers and the amount of tax savings created by shelters. Such a modeling of this interaction may be particularly salient in emerging markets where the possibilities of managerial diversion are more stark. In the American setting, the interaction might be more subtle. In order to capture this dynamic in a setting where safeguards against direct theft are more prevalent, Desai and Dharmapala (2006) consider an interaction between the ability to reduce taxable income and inflate book income in a setting of dual reporting. These alternative perspectives can be thought of as, narrowly, an "agency perspective on tax avoidance" or, more broadly,...
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