In our forthcoming Journal of Accounting Research paper, Equity Risk Incentives and Corporate Tax Aggressiveness, we examine equity risk incentives as one determinant of corporate tax aggressiveness. As noted by Shevlin [2007], we have an incomplete understanding of why some firms are more tax aggressive than others. Prior accounting research finds that corporate tax avoidance is systematically associated with certain firm attributes, including profitability, extent of foreign operations, intangible assets, research and development expenditures (R&D), leverage, and financial reporting aggressiveness. Dyreng, Hanlon, and Maydew [2010] conclude that individual managers influence their firms’ tax avoidance, even after controlling for numerous firm characteristics. Prior research also examines whether income tax avoidance is associated with corporate compensation practices, but finds mixed evidence. We argue that tax avoidance is a risky activity, which imposes costs on both firms and managers. As a result, managers must be incentivized to engage in tax avoidance that involves uncertain outcomes.

Equity risk incentives capture the convexity of the relation between a manager’s wealth and stock price, and are measured as the change in value of a manager’s stock option portfolio for a given change in stock return volatility (e.g., Guay [1999]). In short, equity risk incentives reflect how changes in stock return volatility affect managerial wealth. Prior research provides evidence that equity risk incentives motivate managers to make more risky – but positive net present value – investing and financing decisions. However, these studies do not examine the relation between equity risk incentives and risky tax planning, which we also refer to as “risky tax avoidance” and/or “aggressive tax positions.” We argue that just as equity risk incentives motivate managers to make more risky investing and financing decisions, they also motivate managers to undertake more aggressive (i.e., risky) tax positions, and thus account for some variation in tax aggressiveness across firms.

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