Corporate Governance, Incentives, and Tax Avoidance

There has been a recent surge in research that seeks to understand the sources of variation in tax avoidance (e.g., Shevlin and Shackelford, 2001; Shevlin, 2007; Hanlon and Heitzman, 2010). The benefits of tax avoidance can be economically large (e.g., Scholes et al., 2009) and tax avoidance can be a relatively inexpensive source of financing (e.g., Armstrong et al., 2012). However, aggressive tax avoidance may be accompanied by substantial observable (e.g., fines and legal fees) and unobservable (e.g., excess risk and loss of corporate reputation) costs. Although understanding the factors that influence managers’ tax avoidance decisions is an important research question that has broad public policy implications, relatively little is known about why some firms appear to be more tax aggressive than others.

In our paper, Corporate Governance, Incentives, and Tax Avoidance, which was recently made publicly available on SSRN, we examine whether variation in firms’ corporate governance mechanisms explains differences in their level of tax avoidance. We view tax avoidance as one of many investment opportunities that is available to managers. Similar to other investment decisions, managers have personal incentives to engage in a certain amount of tax avoidance that may not be in the best interest of shareholders, thereby giving rise to an agency problem. From the perspective of the firm’s shareholders, unresolved agency problems with respect to tax avoidance can manifest as either “too little” or “too much” tax avoidance. As with other agency problems, certain corporate governance mechanisms can mitigate agency problems with respect to tax avoidance.

Few papers directly examine the link between corporate governance and tax avoidance. Minnick and Noga (2010) investigate whether several measures of corporate governance are associated with a variety of proxies intended to capture firms’ level of tax avoidance, but find little evidence that governance is associated with avoidance. Desai and Dharmapala (2006) report the surprising result that firms that are poorly governed but where managers have high levels of equity incentives engage in less tax avoidance. They interpret this result as evidence that tax avoidance and managerial rent extraction are complementary activities, which implies that the level of a firm’s tax avoidance is increasing in the strength of its corporate governance. Rego and Wilson (2012) find that firms at which managers have high risk-taking equity incentives engage in more tax avoidance. However, they fail to find any evidence that governance mechanisms—other than executives’ equity incentives—affect this relation. In a concurrent paper, Robinson et al. (2012) examine the association between tax avoidance and audit committee financial expertise. They report evidence that audit committee financial expertise is generally positively associated with tax planning, but that this association is negative where they deem tax planning to be risky (i.e., aggressive). Overall, the few papers that examine the relationships between corporate governance, managerial equity incentives, and tax avoidance have produced results that are quite mixed.

One common theme across prior studies is that their inferences are based on estimates of the conditional mean of the tax avoidance distribution. However, estimates of the conditional mean may not be representative of the relation between governance and tax avoidance at other parts of the tax avoidance distribution. Rather than use traditional econometric methods that focus on either the conditional mean or median of the relation between tax avoidance and corporate governance, we utilize quantile regression to assess this relation across the entire tax avoidance distribution. This research design follows naturally from our conjecture that corporate governance should have a differential impact on extreme levels of tax avoidance. For example, it is possible that boards that better understand the net benefits from tax strategies would encourage more tax planning at lower levels of the tax avoidance distribution because this improves cash flows with little accompanying risk. In contrast, boards might discourage additional tax avoidance at higher levels of the tax avoidance distribution because high tax avoidance may impose costs on the firm (e.g., regulatory or reputation) that exceed the marginal benefits of additional tax savings.

We examine a comprehensive sample of firms between 2007 and 2010 and find that CEOs’ risk-taking equity incentives exhibit a positive relationship with the level of tax avoidance. More importantly, we find that this relationship is stronger in the upper tail of the tax avoidance distribution. This result is consistent with managerial risk-taking incentives being an important determinant of aggressive tax choices that are likely to entail more risk. We also assess the impact of other governance mechanisms on firms’ tax avoidance. In particular, we examine attributes of the board of directors, including representation by financial experts and the independence of directors, as measures of the awareness of the net benefits of investment in tax avoidance and the ability to monitor managers’ tax avoidance decisions. We find that the relationship between board financial expertise/independence and firms’ level of tax avoidance varies substantially across the (conditional) tax avoidance distribution. Specifically, we observe a positive relation in the lower tail of the tax avoidance distribution, which is likely to be symptomatic of under-investment in tax avoidance. In contrast, we observe that this relation is negative in the upper tail of the tax avoidance distribution, which is likely to be symptomatic of over-investment in tax avoidance. Together, these findings suggest that more financially sophisticated and independent boards recognize the potential agency problems that would otherwise give rise to extreme levels of tax avoidance and, in these cases, constrain managers’ tax avoidance decisions.

Consistent with the results in Desai and Dharmapala (2006), we do not find a relation between tax avoidance and an interaction between their indicator for “good” governance and a measure of top executives’ stock option compensation using ordinary least squares (OLS) estimates of the conditional mean. However, quantile regression estimates indicate that there is a negative relation between tax avoidance and the interaction between “good” governance and stock option compensation in the upper tail of the tax avoidance distribution and no relation in the lower tail. These estimates suggest that the interaction between executive stock option compensation and “good” corporate governance mitigates over-investment in high levels of tax avoidance. Thus, in contrast to Desai and Dharmapala (2006), we find that corporate governance appears to be related to managers’ tax avoidance decisions, but only for high levels of tax avoidance.

The full paper is available for download here.