Equity Risk Incentives and Corporate Tax Aggressiveness

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.

The benefits of aggressive tax positions are straightforward. They reduce tax liabilities, which increase cash flow and can also increase after-tax net income. However, aggressive tax positions also impose significant costs on firms and their managers. They require managers to invest substantial resources in the form of fees paid to accountants and attorneys, as well as the time that they and their employees devote to planning for and resolving audits with tax authorities. Costs can increase significantly if tax authorities are successful in challenging an aggressive tax position. For example, in 14 cases of tax sheltering, Wilson [2009] finds the interest charges paid by firms to tax authorities amounted to 40 percent of the tax savings originally generated by the tax shelter transactions. Firms can also suffer reputational penalties, not only in future audits with tax authorities, but also if aggressive tax avoidance becomes public knowledge and affects investors’ assessments of firm value (e.g., Hanlon and Slemrod [2009]).

Thus, in the absence of equity risk incentives, risk-averse managers likely prefer to undertake less risky tax planning, while risk-neutral shareholders prefer managers to undertake all positive net present value tax strategies, regardless of risk. Consistent with prior research (Jensen and Meckling [1976]; Smith and Stulz [1985]), we assume that firms rely on equity-based compensation to align managerial incentives with those of shareholders. Based on Guay’s [1999] theory of equity risk incentives, we predict that equity risk incentives motivate managers to undertake risky but positive net present value tax strategies.

We utilize three existing measures of tax avoidance, including discretionary book-tax differences, tax shelter prediction scores, and cash effective tax rates. We also estimate the amount of unrecognized tax benefits that sample firms have accrued under Interpretation No. 48 (FIN 48) and use this amount as our fourth measure of tax risk. Our model of unrecognized tax benefits can be used by other researchers to estimate unrecognized tax benefits, which typically require the hand-collection of tax footnote data.

Our results consistently indicate that greater equity risk incentives are associated with higher tax risk; however, higher tax risk does not necessarily imply greater equity risk incentives. These findings are robust to alternative estimation methods (i.e., simultaneous system of equations vs. OLS with lagged instrumental variable). We also find little evidence that the relation between equity risk incentives and risky tax avoidance varies by strength of corporate governance. Overall, we infer that equity risk incentives cause managers to undertake risky tax strategies in an effort to increase stock return volatility, and thus the value of their option portfolios.

Our study extends prior research that investigates whether equity risk incentives motivate managers to undertake risky projects, including investing and financing decisions, and complements studies that investigate the link between ETRs, tax sheltering, and executive compensation practices. Our results suggest a need for future research that directly investigates whether – and in which contexts – tax avoidance is conducive to managers extracting rents from the firm. Lastly, our study complements results in Dyreng, Hanlon, and Maydew [2010], which finds that CEOs, CFOs, and other top managers have a significant impact on both GAAP and cash effective tax rates. Our findings offer at least one reason why individual CEOs and CFOs may decide to engage in aggressive tax planning: the maximization of stock option portfolio values through managerial risk-taking.

The full paper is available for download here.