Public Pressure and Corporate Tax Behavior

The following post comes to us from Scott Dyreng of the Accounting Area at Duke University, Jeffrey Hoopes of the Department of Accounting & Management Information Systems at Ohio State University, and Jaron Wilde of the Department of Accounting at the University of Iowa.

In our paper, Public Pressure and Corporate Tax Behavior, which was recently made publicly available on SSRN, we examine whether public scrutiny related to firms’ tax avoidance activities has a significant effect on their tax avoidance behavior. In contrast to U.S. regulations that only require disclosure of significant subsidiaries, the U.K.’s Companies Act of 2006 (“Companies Act”) requires firms to disclose the name and location of all subsidiaries, regardless of size or materiality. Although the U.K. law went into effect in 2006, in 2010, ActionAid International, a global non-profit dedicated to ending poverty worldwide, discovered that approximately half of the firms in the FTSE 100 were not disclosing the name and location of all subsidiaries. ActionAid’s finding was prima facie evidence that the Companies House was not enforcing the subsidiaries disclosure requirement. More importantly, the fact that some firms chose not to comply with the law suggests that the cost of disclosing detailed information on subsidiaries was greater than the benefit of a more complete information environment for the non-compliant firms.

The ActionAid discovery came about as part of an attempt to publicly shame FTSE 100 firms for having subsidiaries located in tax haven countries, hoping to increase their willingness to pay taxes. To secure data on FTSE 100 firms’ tax haven use, ActionAid took advantage of the requirement for public firms to disclose the name and location of each of their subsidiaries in two ways. First, ActionAid contacted the Companies House and asked them to enforce the subsidiary disclosure regulation for noncompliant firms. Second, ActionAid directly pressured individual firms to comply. This pressure involved threatening the possibility of negative publicity for non-compliance with the disclosure rules and reminding firms of ActionAid’s previous success in garnering negative media attention aimed at specific firms. The increased pressure was sufficient to bring nearly all FTSE 100 firms into compliance with the disclosure rule within two years of the report.

We use the public pressure instigated by the ActionAid investigations as a natural experiment. We examine whether the public pressure to comply with the subsidiary disclosures rules made tax avoidance more costly by exposing to the public a channel through which tax avoidance takes place, namely the use of subsidiaries located in foreign countries commonly considered tax havens. That is, we ask whether the public pressure to disclose the location of all subsidiaries sufficiently changed the net costs and benefits of tax avoidance and using tax haven operations such that it altered firms’ tax avoidance behavior.

Using a difference in differences research design, we find that FTSE 100 firms that ActionAid specified in the report as not compliant with subsidiary disclosure rules (noncompliant firms) report higher effective tax rates following the public scrutiny, indicating a decrease in tax avoidance relative to FTSE 100 firms that were not affected by the scrutiny (compliant firms). Specifically, our estimates suggest a 3.7 percentage point increase in the effective tax rates (ETRs) of noncompliant firms relative to the effective tax rates of compliant firms in the years following the initial public pressure to comply.

We verify this finding in a number of ways. First, we conduct a placebo test in which we change the time period of the ActionAid scrutiny to one of the two years before it occurred. In this placebo test, we find no evidence of significantly higher ETRs in the pre-scrutiny period. Second, we find that noncompliant firms decreased the proportion of their subsidiaries located in tax havens relative to compliant firms, consistent with the increase in ETRs being driven by noncompliant firms curtailing tax avoidance strategies that involve tax haven subsidiaries.

Third, we provide evidence that the decrease in tax avoidance for noncompliant firms in the post-scrutiny period is stronger in the subsample of firms with a decrease in the percentage of total subsidiaries located in tax haven countries. In addition, we find the decrease in tax avoidance for noncompliant firms in the post-scrutiny period is most pronounced in the subsample of firms that experience a decrease in the percentage of total subsidiaries located in small (“dot”) tax haven countries—countries where subsidiaries are unlikely to have operational substance. These results suggest that noncompliant firms responded to negative public scrutiny by decreasing subsidiary use in locations where they would incur high disclosure costs (e.g., political and reputation costs arising from increased scrutiny from taking authorities, customer and political outcry, or market penalties) and where it would be relatively easy to close subsidiaries without generating significant operating costs.

Finally, we conduct a test to validate our assumption that non-disclosure of subsidiary information was a firm choice motivated by the relative costliness of these disclosures. We examine market returns around a well-publicized ActionAid report that highlights tax haven use by all FTSE 100 firms (Choy et al., 2014). We find that the short-window market returns for firms that initially did not disclose their subsidiary list are significantly more negative than returns for firms that initially disclosed, demonstrating one cost (market penalties) of public scrutiny related to noncompliant firms’ use of subsidiaries in tax haven nations. In combination, the results are consistent with noncompliant firms failing to initially disclose the full list of their subsidiaries because they perceived costs to the disclosure and that such costs are associated with their corporate tax behavior.

This study contributes to the literature in a several ways. First, our evidence suggests that activist groups can have a meaningful influence on firm outcomes, improving our understanding of the role of non-traditional monitors in overseeing firms’ behavior (Dyck et al., 2010). This evidence is consistent with other research indicating that firms respond to pressure from external stakeholders (Smith, 1995), internal employees (Wilde, 2013), and non-binding shareholder votes (Ertimur et al., 2012). Second, our study provides evidence that firms behave as though public scrutiny of tax avoidance activities is costly, complementing survey evidence in Graham et al., (2013), who find that reputational concerns are a significant deterrent to corporate tax avoidance.

Third, this study contributes to research examining the role of enforcement in other financial settings (Bushman et al., 2005; Daske et al., 2008) by highlighting how non-regulator external party scrutiny can facilitate and encourage enforcement efforts that have significant economic implications for firms. Our results suggest that firms do not always comply with written laws, but that public pressure to comply with existing laws can change both corporate behavior and government enforcement of existing laws. Fourth, our study is informative to policy debates regarding the granularity of firm disclosures related to geographic operations and the taxes paid to the governments in which these operations are located (e.g., the OECD’s initiative on country by country reporting). Finally, our study provides evidence of real consequences to disclosure of subsidiary locations, particularly as they relate to tax avoidance. While much of the work in the tax literature examines economic and managerial determinants of tax avoidance, our study provides evidence that firms incur real tax costs following public pressure to disclose the location of all subsidiaries. Moreover, the results suggest that firms potentially incur real non-tax costs associated with altering their corporate organizational structure to avoid disclosing too many subsidiaries located in tax haven countries.

The full paper is available for download here.

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