Manager-Shareholder Alignment, Shareholder Dividend Tax Policy, and Corporate Tax Avoidance

The following post comes to us from Dan Amiram of the Accounting Division at Columbia University, Andrew Bauer of the Department of Accountancy at the University of Illinois at Urbana-Champaign, and Mary Margaret Frank of the Darden School of Business at the University of Virginia.

In our paper, Manager-Shareholder Alignment, Shareholder Dividend Tax Policy, and Corporate Tax Avoidance, which was recently made publicly available on SSRN, we move away from equity compensation as a measure of manager-shareholder alignment and exploit a unique setting exogenous to the firm to assess the effect of manager-shareholder alignment on corporate tax avoidance. Our setting capitalizes on variation in the value to shareholders from corporate tax avoidance, which is driven by a country’s shareholder dividend tax policy. Firms in the United States, such as the ones examined in the prior literature, are subject to a classical tax system. Corporate earnings are taxed at the firm level and then again at the shareholder level when they are distributed as a dividend (i.e., double taxation). Therefore, corporate tax avoidance increases after-tax cash flows creating either more private benefits for managers or higher after-tax cash flows to shareholders. Other countries around the world employ an imputation tax system. In contrast to a classical system, an imputation system imposes taxes on corporate earnings at the firm level, but these corporate taxes paid are credited against the shareholders’ taxes when earnings are distributed as dividends. This credit causes the total tax paid on earnings to be equal to the shareholders’ tax (i.e., single taxation), so corporate tax avoidance increases after-tax cash flows available for managers’ private benefits but does not increase the after-tax cash flows to shareholders. Because corporate tax avoidance is costly, it actually reduces the after-tax cash flows to shareholders under an imputation system and makes them worse off.

The difference between the effects of corporate tax avoidance on shareholders’ after-tax cash flows in imputation countries as compared to classical countries creates a unique setting to examine the role of the manager in corporate tax avoidance. For managers of firms residing in countries with classical systems, private benefits from diverting corporate resources and shareholders’ benefits from corporate tax avoidance exist. For managers of firms residing in countries with imputation systems, the private benefits assumed in Desai and Dharmapala (2006) exist, but reduced, if any, value to shareholders from corporate tax avoidance exists. If manager-shareholder alignment encourages managers to engage in corporate tax avoidance to benefit shareholders, we will find corporate tax avoidance is higher for firms residing in countries with classical tax systems as compared to imputation tax systems. However, no difference between the countries is consistent with manager-shareholder alignment discouraging corporate tax avoidance as found in Desai and Dharmapala (2006).

We use a sample of 52,895 firm-year observations from 1994 through 2008 across 28 OECD countries to examine the effect of countries’ shareholder dividend tax policies on corporate tax avoidance. To minimize the effect of confounding variables, we use difference-in- differences estimations to examine the effect of changes in countries’ imputation systems on corporate tax avoidance. As predicted, we find that in the years after a country eliminates its imputation system, firms from these countries increase their corporate tax avoidance activities relative to firms from countries that did not change their shareholder dividend tax policy. We extend this analysis by examining the differential impact of the elimination of the imputation systems on firms, based on dividend payout and multinational operations and find results consistent with corporate tax avoidance driven by shareholder alignment. Moreover, we find evidence of a decrease in corporate tax avoidance for firms from Australia as compared to other countries beginning in 2003, following an exogenous increase in the availability of imputation credits in Australia. Our results are robust to the use of different common measures of corporate tax avoidance and the inclusion of controls shown to affect corporate tax avoidance in an international setting.

Results from sensitivity tests using pooled, cross-sectional analyses confirm that corporate tax avoidance for firms from countries with full imputation systems is lower than for firms from partial imputation systems; both are lower than firms from non-imputation systems. Moreover, within imputation countries, corporate tax avoidance is lower for firms with a greater percentage of closely-held shares, while firms with more closely-held shares from classical systems exhibit more corporate tax avoidance. These results suggest firm characteristics that create a stronger alignment between managers and shareholders accentuate the shareholders’ incentives to engage in corporate tax avoidance created by a country’s tax system.

The main contribution of the paper is that our findings provide evidence that corporate tax avoidance by managers is driven by the alignment of their interest with shareholders. As a result, when the shareholders’ benefits from lower corporate taxes are eliminated, corporate tax avoidance falls. This evidence contributes to the debate on corporate tax avoidance in the media, policy circles and the academic literature. This study also contributes to the broader finance literature and tax policy. First, the study provides evidence that in equilibrium contracts are written such that managers around the world act as if they are well-aligned with shareholders. Corporate managers reduce tax avoidance activities when it is not in their shareholders’ interests but still benefits them. Second, the study suggests that taking advantage of the alignment between managers and shareholders should be a consideration in the design of policies to reduce corporate tax avoidance.

This study makes further contribution by connecting two streams of literature on corporate tax avoidance. The literature on the effect of managerial incentives on corporate tax avoidance focuses exclusively on firms from the United States and ignores the variation in managerial incentives for corporate tax avoidance around the world, which is driven by country- level tax policies. On the other hand, Atwood et al. (2012) is the first study to analyze the effect of country-specific tax system characteristics on corporate tax avoidance, but ignores the agency conflicts inherent in corporate tax avoidance. Specifically, they examine the effects of a country’s international tax system (worldwide versus territorial) and corporate statutory tax rates, as well as a country’s level of enforcement and book-tax conformity, on corporate tax avoidance. They implicitly assume manager-shareholder alignment across countries in their analysis of the effect of a country’s tax system on corporate tax avoidance. Our results provide evidence that their implicit assumption is descriptive.

This study also sheds light on potential unintended consequences of the European Union’s effort to harmonize the tax consequences of its residents. In 2004 and 2005, the European Court of Justice (ECJ) ruled that several imputation systems in place throughout Europe were discriminatory. That is, the countries’ imputation systems favored their residents over non-residents. To avoid discrimination, many European countries began to eliminate their imputation systems, but at what cost? While the objective of the ECJ’s ruling is well-intended, it may have unknowingly increased corporate tax avoidance in Europe. Our evidence speaks to concerns over the ECJ’s attempts to harmonize tax policy, through its rulings at the expense of its member states, and the potential negative impact on members’ tax revenues (Graetz and Warren 2006).

While the findings in this study have important policy implications, we offer a word of caution. Our study speaks to one aspect of tax policy; however, tax policy is a complex issue in a global economy with many competing objectives. For example, Amiram and Frank (2012) show that imputation systems deter foreign equity portfolio investors. In addition, any declines in corporate tax avoidance under an imputation system may increase the shareholders’ incentives to avoid personal taxes.

The full paper is available for download here.

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