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Here’s Another Reason to Avoid Tax Avoidance

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Aggressive tax planning sows confusion not only about companies’ taxes but also about the basics of their operations and finances.

A year ago, a paper in the American Accounting Association journal The Accounting Review featured a surprising finding: CEOs are at increased risk of losing their jobs not only if their companies pay much more than their peers in taxes, but also if they pay much less, reports CFO News.

The authors credited legislative, regulatory, and judicial initiatives with raising public sensitivity to companies’ tax-aggressiveness, and surmised that the sharply reduced corporate tax rates under the Tax Cuts and Jobs Act would likely inhibit aggressive tax planning further.

Now, a study in the current issue of the journal may very well reinforce that inhibition. The research finds that the complicated ploys that often characterize aggressive tax planning sow uncertainty and even confusion not just about companies’ taxes but about the basics of their operations and finances, with resultant negative outcomes.

The authors, Jennifer Blouin and Wayne Guay of the Wharton School of the University of Pennsylvania and Karthik Balakrishnan of the London Business School, found that “tax-aggressive firms have lower corporate transparency” than less-aggressive peers.

And poor transparency, they wrote, “has been shown to impose an array of costs on firms, such as lowering liquidity and trading volume, raising both the debt and equity costs of capital, exacerbating governance problems, and reducing investment efficiency.”

What is the evidence that tax-aggressiveness diminishes transparency?

“Specifically,” the professors wrote, “we find that firms with unusually low tax liabilities within their industry/size grouping have larger analysts’ forecast errors, greater analysts’ forecast dispersion, and a higher level of information asymmetry.”

They added that “transparency issues extend beyond investors’ and analysts’ understanding of tax expense [so that] analysts have greater difficulty forecasting pre-tax income.”

Further, the degree to which tax aggressiveness diminishes transparency can be quite considerable. If, for example, the extent of a company’s tax avoidance is among the highest in its industry/size grouping, analyst forecast errors (that is, the amount analysts err in forecasting company earnings) will be close to 25% greater than for a company whose tax avoidance is at the group’s median.

Comments Blouin, “Aggressive tax avoidance often involves a considerable increase in companies’ financial and organizational complexity, which can make it exceedingly difficult for outsiders to assess the firms’ overall finances. Thus [it’s important] for top management of those companies to [provide] as much clarity as possible about their structures and operations.”

And indeed, tax-aggressive managers often do take steps in that direction, according to the paper, despite the possibility that transparently disclosing the organizational details related to certain tax strategies would provide a roadmap for an audit by tax authorities.

That risk notwithstanding, the researchers found that, compared with less-aggressive peers, “tax-aggressive firms, on average, provide more detailed management discussion and analysis [in their annual reports] as well as hold conference calls that are lengthier.”

In sum, it appears that “managers recognize the transparency issues that surround aggressive tax strategies and on average provide supplemental disclosure that may alleviate some of the difficulties faced by investors that analyze these firms.”

As to how effective these extra efforts are, the evidence is mixed. Tax-aggressive companies whose earnings calls are above average in length generally see significantly more accuracy in analyst forecasting than do similarly aggressive firms whose conference calls are shorter than average.

In contrast, longer-than-average expositions by tax-aggressive firms in the “management discussion and analysis” sections of annual reports do not seem to enhance analyst forecasting any more than shorter ones do.

Given the opacity that aggressive tax planning occasions, do corporate managers undertake it for their personal enrichment?

To test that, the professors analyzed the extent to which indicators of strong company governance — such as board independence and CEO-chairman separation — are associated with enhanced transparency (as measured by analyst forecast errors) and with increased efforts at transparency (such as by lengthy discussions of management in company annual reports).

The fact that no significant differences in these associations emerge between strongly and weakly governed firms suggests that personal enrichment for top management is generally not a major incentive in aggressive corporate tax planning.

The study’s findings are based on 40,193 firm-years of data from U.S.-based public companies over a 14-year period. Tax aggressiveness was measured on the basis of the amount of taxes a company owed or paid compared with the average for firms of similar size in the same industry. Firms carried out operations in a mean of about three locations classed as tax havens, although more than half operated in none.

The study, entitled “Tax Aggressiveness and Corporate Transparency,” is in the January issue of The Accounting Review.