Study finds aggressive tax strategies can lead to investor confusion
Complicated, aggressive corporate tax-planning strategies can produce uncertainty and confusion among investors not only about the companies’ taxes, but also the basics of their operations and finances, leading to some negative outcomes, according to a new academic study.
The study, by Jennifer Blouin and Wayne Guay of the University of Pennsylvania’s Wharton School and Karthik Balakrishnan of the London Business School, appears in the January issue of The Accounting Review, published by the American Accounting Association. It found that “tax-aggressive firms have lower corporate transparency” than less aggressive companies, which “has been shown to impose an array of costs on firms, such as lowering liquidity and trading volume, raising both the debt and equity costs of capital, exacerbating governance problems, and reducing investment efficiency.”
Aggressive tax strategies can result in some negative outcomes for companies. “Specifically, we find that firms with unusually low tax liabilities within their industry/size grouping have larger analysts’ forecast errors, greater analysts’ forecast dispersion, and a higher level of information asymmetry,” they wrote.
Tax aggressiveness can be difficult for investors and financial analysts to deal with in their forecasts, and “transparency issues extend beyond investors’ and analysts’ understanding of tax expense [so that] analysts have greater difficulty forecasting pre-tax income.”
Tax aggressiveness can reduce transparency in significant ways, according to the research. If the extent of a company’s tax avoidance is among the highest in its industry or size group, the amount that analysts err in forecasting the company earnings are close to 25 percent greater than for a company whose tax avoidance is in the group’s median range.
“Aggressive tax avoidance often involves a considerable increase in companies’ financial and organizational complexity, which can make it exceedingly difficult for outsiders to assess the firms’ overall finances,” stated Blouin. “Thus the importance for top management of those companies to go an extra mile in providing as much clarity as possible about their structures and operations.”
Executives at tax-aggressive companies may explain some of their tactics during earnings calls and annual reports, but that too can backfire. “Transparently disclosing the organizational details related to certain tax strategies …would provide a roadmap for an audit by the tax authorities,” said the paper, but despite that risk, the researchers found that, compared to less aggressive peers, “tax-aggressive firms, on average, provide more detailed management discussion and analysis in their annual reports as well as hold conference calls that are lengthier.” They contend that “managers recognize the transparency issues that surround aggressive tax strategies and on average provide supplemental disclosure that may alleviate some of the difficulties faced by investors that analyze these firms.”
The results are mixed for companies that disclose their tax strategies. Those whose conference calls are above average in length generally see significantly more accuracy in analyst forecasting than do similarly aggressive companies whose conference calls are shorter than average, according to the research. In contrast, longer-than-average explanations by tax-aggressive companies in the “management discussion and analysis” sections of annual reports filed with the SEC don’t seem to improve analyst forecasts any more than shorter ones do. “Message for tax-aggressive managers: Don’t constrict your conference calls,” said Blouin.
Does aggressive tax-planning by corporate managers contribute to their personal enrichment, the researchers wondered. To answer this question, they analyzed the extent to which indicators of strong company governance, such as board independence and separation of the CEO and chairman roles, are associated with enhanced transparency (as measured by analyst forecast errors) and with greater efforts at transparency (such as by lengthy discussions of management in company annual reports). They found no significant differences between strongly and weakly governed companies, suggesting that personal enrichment for top management was generally not a major incentive behind aggressive corporate tax planning.
The findings were based on 40,193 company years of data from U.S.-based public companies over a 14-year period. Tax aggressiveness was measured according to the amount of taxes a company owed or paid compared to the average for firms of similar size in the same industry. Companies carried out operations in an average of about three locations classed as tax havens, although more than half operated in none.