Corporate Tax Avoidance: Literature Review On Methods

Corporate Tax Avoidance 10literature Review On Methods Of Measuring Co

Corporate Tax Avoidance (CTA) has diverse meanings depending on different perspectives, and there is no universally agreed-upon definition. Scholars point out that the practices classified as tax avoidance are often misinterpreted, as the boundary between legitimate tax planning and illegitimate tax evasion remains blurred (Lanis & Richardson, 2011). Legality, legitimacy, and ethical considerations complicate the classification of tax activities, with terms like tax aggressiveness, planning, and management often used interchangeably in the literature. A broad understanding describes tax avoidance as the capacity to reduce tax liabilities using legal strategies, with some definitions including both legal and illegal activities, depending on context and perception.

Several researchers have contributed to conceptualizations of CTA. Dyreng, Hanlon, and Maydew (2008) define tax avoidance as the ability to pay less tax per dollar of pre-tax accounting income, emphasizing managerial actions aimed at minimizing tax burdens. Conversely, Frank, Lynch, and Rego (2009) suggest that CTA involves downward manipulation of taxable income through tax planning, which may border on fraudulent practices but is not necessarily unlawful. Chen, Cheng, and Shevlin (2010) broaden this perspective, including both legitimate and illegal strategies, creating a gray area that complicates clear classification. Hanlon and Heitzman (2010) depict tax avoidance as a chain of tactics where items like bond investments and sheltering are at one end, and aggressive tax strategies are near the other, emphasizing the spectrum of tax planning activities impacting a firm’s tax liability.

Measures of Tax Avoidance

Measuring corporate tax avoidance involves analyzing tax liability and taxable income, which can be obtained from financial statements or tax returns. Due to confidentiality issues with tax returns, researchers predominantly use financial statement data, despite discrepancies arising from differing regulation and accounting standards (Wilson, 2009). Several methods have been developed to quantify CTA, each with distinct features and limitations.

Effective Tax Rate (ETR)

The most commonly employed measure is the Effective Tax Rate (ETR), which assesses the proportion of taxes paid relative to accounting income (Chen et al., 2010). Variations include accounting ETR (GAAP ETR), current ETR, and long-run cash (LRC) ETR. Accounting ETR is calculated as total tax expense divided by pre-tax accounting income, providing a snapshot of tax efficiency over a specific period. Studies have used it to examine the association between tax strategies and firm ownership, managerial influence, and corporate governance (Dyreng et al., 2010; Armstrong et al., 2012). However, this measure primarily captures tax avoidance relative to accounting incomes and may overlook deferred tax strategies or timing differences.

Current ETR and Long-Run Cash (LRC) ETR

Current ETR considers the annual tax expense over accounting revenue, reflecting immediate tax planning and deferrals. It provides insight into a firm's short-term tax strategies, but its volatility can distort longitudinal comparisons (Hope, Ma, & Thomas, 2012). Conversely, LRC-ETR integrates cash tax payments over multiple years (typically 3-10 years), smoothing out year-to-year fluctuations and capturing long-term tax planning strategies (Dyreng et al., 2008; Minnick & Noga, 2010). This approach is considered superior for assessing persistent tax avoidance but requires extensive historical data (Hanlon & Hietzman, 2010).

Income Tax Expense (ITE) and Cash Taxes Paid (CTP)

ITE assesses the proportion of income tax expense relative to operating cash flows, emphasizing actual cash outflows related to taxes (Lanis & Richardson, 2012). On the other hand, CTP measures real cash taxes paid, representing a more conforming indicator of tax avoidance. Although promising, CTP's practical application is limited due to data availability and reporting consistency (Hanlon & Hietzman, 2010).

Book-Tax Gap (BTG)

The BTG measures the disparity between financial statement income and taxable income, with the gap indicating potential tax avoidance or earnings management. Manzon and Plesko (2002) introduced the total BTG, while Chen et al. (2010) refined it to include residual BTG, which isolates the unexplained portion attributable to tax strategies. Hanlon and Hietzman (2010) proposed the tax-effect BTG, focusing on variation in current versus income tax expenses, providing a nuanced understanding of permanent and temporary differences impacting CTAs.

DTAX

DTAX quantifies differences between a firm's effective tax rate and the statutory corporate tax rate. Variation suggests aggressive tax strategies or tax planning efficiencies. Armstrong, Blouin, and Larcker (2012) used DTAX to analyze the impact of executive incentives on tax aggressiveness, indicating its utility in behavioral studies. It’s particularly suited for understanding less transparent or more aggressive avoidance tactics.

Tax Shelter Measures

Wilson (2009) developed models to identify firms engaged in tax sheltering, based on profiles of firms accused of shelter fraud. Although this measure provides direct insight into overt sheltering activities, it is subject to self-selection bias, as many firms may avoid taxes through other means without employing shelters (Hanlon & Hietzman, 2010). Consequently, it measures the extreme end of tax avoidance behaviors rather than the broader spectrum.

Conclusion

The review of existing methodologies highlights that multiple measures—such as ETR variations, BTG, and DTAX—successfully capture non-conforming tax avoidance activities. Nonetheless, the cash taxes paid (CTP) measure emerges as a promising candidate for capturing conforming, long-term tax strategies, given its focus on actual cash outflows and minimal manipulation. However, further empirical validation is essential to establish its efficacy and reliability. Advances in data collection and methodological refinement are crucial for developing more precise and comprehensive measures of corporate tax avoidance, contributing to both academic understanding and policy formulation.

References

• Armstrong, C. S., Blouin, J. L., & Larcker, D.. (2012). The incentives for tax planning. Journal of Accounting and Economics, 53(1), 1–31.
• Chen, S., Chen, X., Cheng, Q., & Shevlin, T. (2010). Are family firms more tax aggressive than non-family firms? Journal of Financial Economics, 95(1), 41-61.
• Dyreng, S. D., Hanlon, M., & Maydew, E. L. (2008). Long-run corporate tax avoidance. The Accounting Review, 83(1), 61–82.
• Hanlon, M., & Heitzman, S. (2010). A review of tax research. Journal of Accounting and Economics, 50(2), 127–178.
• Hanlon, M., & Hietzman, S. (2010). The effect of book-tax differences on the valuation of growth options. Journal of Accounting and Economics, 50(2), 329–343.
• Lanis, R., & Richardson, G. (2011). The effect of board of director composition on corporate tax aggressiveness. Journal of Accounting and Public Policy, 30(1), 50–70.
• Lanis, R., & Richardson, G. (2012). Corporate social responsibility and tax aggressiveness: An empirical analysis. Journal of Accounting and Public Policy, 31(1), 86–108.
• Mannot Jr, G. B., & Plesko, G. A. (2002). The relation between financial and tax reporting measures of income. MIT Sloan Working Paper.
• Minick, K., & Noga, T. (2010). Do corporate governance characteristics influence tax management? Journal of Corporate Finance, 16(5), 703–715.
• Wilson, R. J. (2009). An examination of corporate tax shelter participants. The Accounting Review, 84(3), 969–999.