Equity Compensation and Tax Avoidance:
Disentangling Managerial Incentives from Tax Benefits and
Reexamining the Effect of Shareholder Rights
Jeri K. Seidman
University of Virginia
[email protected]
Bridget Stomberg*
University of Georgia
[email protected]
November 2016
Much empirical evidence is consistent with properly incentivized executives engaging in
more tax avoidance. However, other studies provide evidence consistent with tax avoidance
facilitating managerial rent extraction. We address these mixed results by reexamining some of
the earliest empirical evidence that tax avoidance and rent extraction are complementary
activities. Specifically, we reexamine the negative relation between executives’ equity
compensation and tax avoidance that is concentrated in firms with weaker shareholder rights.
Although this pattern of results is consistent with complementarities between tax avoidance and
rent extraction, we propose it is also consistent with tax exhaustion theory because the
substantial tax benefits from equity compensation reduce firms’ demand for additional tax
avoidance. We also draw on recent findings that suggest shareholder rights indices are
problematic as a measure of corporate governance in the context of tax avoidance. Our results
suggest tax exhaustion is a more compelling explanation for cross-sectional differences in the
relation between executives’ equity compensation and tax avoidance. Further, failing to control
for tax avoidance opportunities when using shareholder rights indices can confound inferences.
Although our analyses do not disprove the notion that managers can use tax avoidance to
facilitate rent extraction, they challenge the interpretation of some of the earliest empirical
evidence in support of the theory that this behavior is widespread.
Acknowledgements: We thank Benjamin Ayers, Linda Bamber, Jennifer Blouin (discussant),
Shuping Chen, Lisa De Simone, Steven Kachelmeier, Kenneth Klassen (editor), Lillian Mills,
John Robinson, Casey Schwab, Douglas Shackelford, two anonymous referees, the Arizona State
Tax Readings Group, and participants in workshops at the American Accounting Association
2011 Annual Meeting, the University of Colorado, the University of Texas, and the 2011 Lone
Star Accounting Research Conference for valuable comments and suggestions. For financial
assistance, Seidman thanks the PWC Center for Innovation in Professional Services.
JEL: H25, H26, M41, M52
Keywords: Tax avoidance, equity incentives, tax benefits from equity compensation
*Corresponding author: Stomberg can be reached at (706) 542-3626, The University of Georgia,
Terry College of Business, 234 Brooks Hall, Athens, GA 30602.
1 Introduction
Tax avoidance can enhance shareholder value by decreasing cash payments to tax
authorities. Agency theory therefore predicts that shareholders incentivize managerial effort to
minimize taxes until the costs and benefits of tax avoidance are balanced. Many empirical
studies are consistent with the notion that managers’ incentives are positively associated with
corporate tax avoidance (Gaertner 2014; Hanlon, Mills and Slemrod 2007; Phillips 2003;
Powers, Robinson and Stomberg 2016; Robinson, Sikes and Weaver 2010; Rego and Wilson
2012). However, Desai, Dyck and Zingales (2007) cast doubt on whether tax avoidance enhances
shareholder value in all firms by proposing that in the absence of strong corporate governance,
loose tax enforcement can enable both tax avoidance and managerial rent extraction. In a case
study of four Russian oil firms, the authors estimate that an increase in revenue authority scrutiny
was associated not only with increased tax revenues but also with increased corporate income
and dividends. Subsequent studies provide evidence consistent with the notion that tax avoidance
can destroy firm value by facilitating managerial opportunism.1
Desai and Dharmapala (2006) explore the relation between managerial incentives and
corporate tax avoidance while building on the notion from Desai et al. (2007) that positive
feedback effects can exist between tax avoidance and rent extraction. 2 They model how
increased incentive alignment can lead to either an increase or a decrease in tax avoidance, with
the direction of the effect depending on whether tax avoidance and rent extraction are
complements or substitutes. If tax avoidance and rent extraction are complements, the model
1
For example, Armstrong, Blouin, Jagolinzer and Larcker (2015) suggests that strong governance reduces extremely
high levels of tax avoidance, and a number of papers estimate that equity investors and debt holders do not
unilaterally reward tax avoidance (e.g., Desai and Dharmapala 2009, Hasan, Hoi, Wu and Zhang 2014, Kim, Li and
Zhang 2011, Wilson 2009).
2
Although the authors do not explicitly model tax avoidance and rent extraction as complements, Desai et al. (2007)
state that “[m]ost transactions aimed at diverting corporate value toward controlling shareholders also reduce
corporate tax liabilities (p. 392)”.
1
predicts that the overall association should be more negative (or less positive) in poorly governed
firms than in well-governed firms because the ex ante cost of rent extraction is low enough in
poorly governed firms to allow managerial diversion. Using the percentage of executives’ total
compensation derived from equity as a measure of incentive alignment, the authors document a
negative overall association between executives’ incentives and tax avoidance that is driven by a
subset of firms with weaker shareholder rights. They find no association among firms with
relatively stronger shareholder rights. The authors conclude this pattern of results is consistent
with the idea that tax avoidance and rent extraction are complementary activities.
The authors acknowledge that a negative overall association between incentive
compensation and tax avoidance is “counterintuitive” given the long-standing view that tax
avoidance is “pro-shareholder” (p. 166). Beyond running counter to predictions stemming from
other theoretical and empirical work, this finding also implies that the average U.S. firm is
governed poorly enough to allow managers to extract rent through tax avoidance. An alternative
explanation for the negative overall association is that firms issuing substantial equity
compensation enjoy greater tax benefits than other firms, all else equal, and therefore engage in
fewer additional tax avoidance strategies. This explanation, which is consistent with tax
exhaustion theory, is a plausible explanation for this pattern of results because of how Desai and
Dharmapala (2006) measure equity incentives and tax avoidance.3
Tax exhaustion theory proposes that as taxable income approaches zero and the marginal
benefits of additional tax avoidance decline, taxpayers engage in less incremental tax avoidance.
3
The authors acknowledge tax exhaustion theory as a plausible alternative explanation for their results. In a
robustness test, they eliminate 59 observations where estimated taxable income adjusted for the estimated tax benefit
of executives’ option exercises is non-positive, and report that results remain unchanged. However, this analysis
does not substantially alter the original sample. Thus, we perform a battery of analyses using alternative proxies for
nearness to tax exhaustion to more thoroughly examine the role that tax exhaustion plays in the relation between
equity incentives and tax avoidance.
2
This theory is therefore consistent with an overall negative relation between equity compensation
and tax avoidance. During the sample period in Desai and Dharmapala (2006), which spans from
1993 through 2001, many firms enjoyed substantial tax benefits from equity compensation.
Babenko and Tserlukevich (2009) estimate that compensating employees with stock options
generates $12.6 million per year in incremental tax savings relative to paying the same amount
of cash compensation. Graham, Lang and Shackelford (2004) estimate that aggregate option
deductions in 2000 were 10 percent of aggregate pre-tax income for S&P 100 firms and that
aggregate option deductions exceeded aggregate pre-tax income for NASDAQ 100 firms.
However, the proxy for tax avoidance that Desai and Dharmapala (2006) use - domestic booktax differences adjusted for accruals - does not capture these tax benefits in their sample period.4
Therefore, because tax exhausted firms engage in less incremental tax avoidance and because
firms with substantial option deductions are closer to tax exhaustion than other firms all else
equal, the negative overall association between option compensation and non-option-related tax
avoidance could be explained by tax exhaustion theory.
We first examine whether tax exhaustion theory is descriptive of the negative overall
relation between executives’ equity compensation and tax avoidance by testing whether the
relation varies with firms’ proximity to exhaustion. As the extent of equity compensation
increases and the marginal benefit of incremental tax avoidance consequently decreases, we
expect tax-exhausted firms will substitute away from other tax shields more than firms further
from tax exhaustion. In short, tax exhaustion theory predicts a more negative relation between
equity compensation and tax avoidance for tax-exhausted firms. We estimate a negative
4
Prior to the effective date of SFAS 123R, Share Based Payments, for fiscal years beginning after June 15, 2005,
tax benefits from option compensation were not reflected in tax expense but were instead recorded as a component
of shareholders’ equity. Therefore, book-tax difference measures calculated prior to 2006 that are based on financial
statement tax expense do not reflect tax benefits from option compensation, which was the predominant form of
equity-based compensation at this time.
3
association between equity compensation and accruals-adjusted book-tax differences, on
average, which is consistent with the substantial tax benefits of option compensation during the
sample period reducing firms’ demand for other tax avoidance strategies. We also document that
the relation is more negative for firms nearer to tax exhaustion as measured with the existence of
pre-tax losses, high levels of research and development (R&D) expenses and low estimated
marginal tax rates. These results provide evidence that tax exhaustion theory offers a viable
alternative explanation for the negative overall relation between equity compensation and tax
avoidance.
We next examine whether tax exhaustion theory can also explain the result that the
negative overall relation is concentrated in a subset of firms with weaker shareholder rights,
measured using the Gompers, Ishii and Metrick (2013) index. Recent papers reveal features of
the Gompers et al. (2003) index that could limit its usefulness as a measure of corporate
governance broadly as well as in the context of tax avoidance specifically. Johnson, Moorman
and Sorescu (2009) document that some industries are over-represented in certain values of the
Gompers et al. (2003) index. This industry clustering is potentially problematic because tax
avoidance opportunities and, therefore, tax exhausted firms, also likely cluster by industry.
We document that tax exhausted firms cluster in high-technology industries, and that
these industries are over-represented in some parts of the distribution of shareholder rights. This
pattern highlights the importance of considering the effects of both shareholder rights and
nearness to tax exhaustion. For firms in high-technology industries and for other tax exhausted
firms, we estimate a significantly more negative relation between equity compensation and tax
avoidance that is robust to controlling for shareholder rights. Finally, we find little evidence that
the overall negative relation is concentrated among firms with weaker shareholder rights when
4
we use the entrenchment index from Bebchuk, Cohen and Ferrell (2009) to classify shareholder
rights or when we use a different cutoff of the Gompers et al. (2003) index than Desai and
Dharmapala (2006) to identify firms with weaker rights. These analyses provide evidence that
results in support of how shareholder rights moderates the relation are sensitive to either the
measure used or the value used to partition strong and weak shareholder rights.
Our study extends the literature that examines the role of shareholder rights on tax
avoidance. We complement recent studies that find evidence contrary to the notion that tax
avoidance facilitates rent extraction (e.g., Blaylock 2015; Lennox, Lisowsky and Pittman 2013).
Our tests demonstrate that the negative relation between executives’ equity compensation and tax
avoidance cannot only be explained by the theory of complementary activities but also by tax
exhaustion theory. Though we closely follow the research design in Desai and Dharmapala
(2006) to ensure that any results unsupportive of the theory outlined therein are not an artifact of
research design changes, we also examine the impact of alternative design choices and find
results are more consistent with tax exhaustion theory. For example, we find limited evidence
consistent with the theory of complementary activities when we replace accruals-adjusted booktax differences with other measures of aggressive tax avoidance. Although our analyses are not
structured to disprove the notion that managers can use tax avoidance to facilitate rent extraction,
our findings challenge the interpretation of early empirical evidence supporting the notion that
U.S. managers exploit tax avoidance to facilitate rent extraction, on average. Thus, our study has
implications for researchers who rely on the theory of complementary activities to motivate
studies of tax avoidance in the context of agency problems.
Our study also extends the literature on tax exhaustion. Similar to Graham et al. (2004),
our findings suggest that the tax deductions from equity compensation are significant enough to
5
limit firms’ use of other tax avoidance activities. We also highlight the fact that for firms with
significant tax benefits from stock options prior to SFAS 123R, Share-Based Payment, which
requires firms to expense options, some tax avoidance measures can understate the extent of total
tax avoidance. Finally, our results suggest that the shareholder rights index developed in
Gompers et al. (2003) has potential limitations as a measure of cross-sectional differences in
corporate governance when used in a tax setting because tax exhausted firms are overrepresented at certain values of the index. Thus, we recommend that researchers control for
marginal tax rates when using shareholder rights indices as measures of corporate governance in
tax avoidance settings to help minimize the potential for confounded inferences.
2 Background and hypothesis development
2.1 Background
Corporate tax avoidance is a useful setting in which to evaluate agency conflicts.
Shareholders desire a level of tax minimization that appropriately balances the benefits of tax
avoidance with the costs (Crocker and Slemrod 2005). Direct costs to the firm include fees paid
to consultants as well as potential interest and penalties if a tax position is disallowed. Costs to
the manager include time and effort to identify and implement tax planning strategies as well as
potential reputational costs if a tax strategy is not upheld. Agency theory predicts that
shareholders design incentive plans to induce managers to exert costly effort to minimize
expected taxes until the costs and benefits of tax avoidance are appropriately balanced.
Much of the existing archival literature is consistent with the prediction that incentivealigned managers engage in more tax avoidance. Phillips (2003) finds that compensating division
managers on an after-tax basis leads to lower financial effective tax rates (ETRs). Armstrong,
Blouin and Larcker (2012) find a negative association between tax director incentive
6
compensation and GAAP ETRs. Robinson et al. (2010) find that firms with tax departments
evaluated as profit centers, as opposed to cost centers, have lower financial ETRs. Hanlon et al.
(2007) find that the level of equity incentives from exercisable stock options is positively related
to proposed IRS adjustments. Finally, Gaernter (2014) finds that compensating CEOs on aftertax performance measures leads to lower ETRs, and Powers et al. (2016) find that firms using
cash-flow based measures to evaluate their CEOs have greater tax avoidance. Together, these
results suggest that managerial incentive alignment induces tax avoidance.
In contrast, Desai et al. (2007) cast doubt on whether tax avoidance is value-enhancing in
all settings. The authors claim that manager-shareholder and manager-tax authority interactions
create spillover effects that lead to complementarities between tax avoidance and managerial
diversion. In other words, transactions that managers use to extract rents also tend to reduce tax
liabilities. Using four Russian oil firms as a case study, the authors estimate that an increase in
scrutiny from the revenue authority was associated with an increase tax revenues as well as
increases in reported corporate income and dividends.
Desai and Dharmapala (2006) build on this theory and posit that the complementary
nature of rent extraction and tax avoidance allows self-serving managers to use tax shelters to
increase their personal utility by diverting firm resources. The authors propose that managers use
tax shelters, at least in part, to facilitate and obfuscate rent extraction because
“misrepresentations destructive to shareholders can be facilitated by tax avoidance” (p. 157).5
However, as equity compensation aligns managers’ incentives, they derive more personal utility
from enhancing firm value than from extracting rents. Managers therefore reduce their demand
for tax avoidance that facilitates rent extraction and implement new tax avoidance only to the
extent it enhances firm value. Thus, contrary to predictions stemming from traditional agency
5
This theory does not require that the tax shelter itself provides the means for rent extraction.
7
theory, one could observe a negative relation between executive equity compensation and tax
avoidance if the decrease in self-serving tax avoidance outweighs the increase in valueenhancing tax avoidance. We refer to this theory as the “theory of complementary activities”
because it is based on the premise that tax avoidance complements managerial rent extraction.
Desai and Dharmapala (2006) find an overall negative relation between equity
compensation and tax avoidance, which they note is “consistent with a situation in which
positive feedback effects between sheltering and diversion are relatively strong” (p. 166).
Finding an average effect, however, does not provide unambiguous support for the theory of
complementary activities. The theory’s only unambiguous prediction is that the relation will be
less negative in well-governed firms where the ex ante cost of rent extraction is assumed to be
prohibitively high. In well-governed firms, the level of rent extraction is assumed to already be
so low that increases in incentive alignment have little impact on reducing managers’ selfserving tax avoidance. Using the shareholder rights index developed by Gompers et al. (2003) as
a proxy for corporate governance and the cost of rent extraction, the authors demonstrate that
firms with weaker shareholder rights drive the overall negative relation between executives’
equity compensation and tax avoidance. Specifically, they find a negative relation only among
the 75 percent of the sample they classify as having relatively weaker shareholder rights, where
they argue the cost of rent extraction is lowest (and thus, the level of rent extraction is highest).
Subsequent studies provide empirical support consistent with tax avoidance facilitating
rent extraction. For example, Desai and Dharmapala (2009) find that book-tax differences are
positively associated with firm value only for firms with high institutional ownership. The
authors interpret the result as suggesting that investors positively value tax avoidance only when
it appears to be undertaken in the interest of the firm rather than as a means of managerial rent
8
extraction. Similarly, Wilson (2009) finds that firms with strong shareholder rights earn
abnormal stock returns while engaged in tax shelters. Chen, Chen, Cheng and Shevlin (2010)
provide evidence that family-owned firms engage in less tax avoidance than non-family owned
firms and suggest this is because family-owned firms fear minority investors will view tax
avoidance by insiders as a means of rent extraction and discount share prices. Armstrong et al.
(2015) find that strong corporate governance reduces extremely high levels of tax avoidance.
Finally, other papers provide evidence that neither equity investors nor debt holders positively
value tax avoidance in all firms (e.g. Hasan et al. 2014; Kim et al. 2011).
However, other studies provide evidence challenging the notion that rent extraction and
tax avoidance are complements or that shareholder rights affect the association between
managers’ incentives and tax avoidance. Lennox et al. (2013) find that U.S. firms that are
aggressive for tax reporting purposes are less likely to commit accounting fraud. The authors
conclude their results are inconsistent with the theory that “both tax aggressiveness and fraud
require reporting opacity, implying that the two decisions will tend to occur concurrently” (p.
772). Blaylock (2015) uses multiple proxies for managerial rent extraction and finds no evidence
that managers of U.S. firms use tax avoidance as a means of extracting economically significant
rents. Rego and Wilson (2012) find that managerial equity risk incentives are positively related to
several measures of tax avoidance and find no evidence that shareholder rights affect the
relation. Together, these results demonstrate that the relation between managerial incentives, tax
avoidance and corporate governance is not fully understood. We examine the tax benefits of
equity compensation as an alternative mechanism through which equity compensation affects tax
avoidance. In doing so, our study provides additional insights into these relations.
9
2.2 Hypothesis Development
Desai and Dharmapala (2006) state that a negative overall relation between managers’
incentives and tax avoidance is consistent with, but does not provide unambiguous support for,
the theory of complementary activities. Tax exhaustion theory is also consistent with a negative
overall relation between tax avoidance and equity compensation. DeAngelo and Masulis (1980)
show that firms substitute between tax shields as the probability of benefiting from multiple tax
shields decreases. For example, a firm with substantial depreciation deductions will have a
reduced demand for interest deductions because it is unlikely to benefit immediately from both
tax shields. Consistent with these predictions, MacKie-Mason (1990) finds that firms substitute
away from debt when non-debt tax shields are high. Similarly, Graham and Tucker (2006) and
Wilson (2009) present evidence that firms engaged in tax shelters have lower levels of debt. For
these firms, tax shelters provide sufficient tax benefits to attenuate the benefits of debt tax
shields.
Similar to debt or depreciation tax shields, the tax benefits from equity compensation can
be substantial enough, relative to both taxable income and to deductions provided by non-equity
compensation, to influence the level of other forms of tax avoidance. Execucomp data show that
Cisco received a tax deduction of $120 million in 1999 from options exercised by the CEO
alone. Yet his combined salary and bonus was less than $1 million that year. For a sample of
NASDAQ firms, Hanlon and Shevlin (2002) estimate that the tax benefit from stock option
exercises in 1999 reduced taxable income by an average of 46 percent. Adjusting for the tax
benefits of stock options would have reduced these firms’ reported ETR from 37.1 percent to
19.3 percent. Similarly, Babenko and Tserlukevich (2009) use a sample of both S&P 500 and
NASDAQ 100 firms and estimate that compensating employees with stock options generates
10
$12.6 million per year in incremental tax savings relative to paying the same dollars of cash
compensation. Consistent with this evidence, Graham et al. (2004) find that firms with high
option usage appear underleveraged because the tax benefits from options are significant enough
to decrease the marginal tax benefit of additional debt tax shields.
Together, this evidence indicates that the tax benefits from equity compensation can be
sizeable enough to affect tax avoidance decisions. We will observe an overall negative relation
between equity compensation and other forms of tax avoidance if exhausted firms substitute
away from other tax shields. This is particularly true in the sample period studied in Desai and
Dharmapala (2006) – 1993 through 2001 – during which time most firms did not expense option
compensation against book income and did not reflect the tax benefits of options in financial
statement tax expense. Thus, measures of tax avoidance derived from estimated book-tax
differences do not include the tax benefits of options prior to the mandated expensing of stock
options under SFAS 123R, Share-Based Payment, for fiscal years beginning after June 15, 2005.
In summary, like the theory of complementary activities, tax exhaustion theory is also consistent
with an overall negative relation between equity compensation and tax avoidance because firms
that expect significant tax benefits from equity compensation likely engage in less other tax
avoidance.
MacKie-Mason (1990) demonstrates that the substitution between available tax shields
becomes stronger as taxpayers move closer to exhausting their current tax liability and losing the
immediate benefits of their tax shields. In other words, firms will engage in less tax avoidance as
the marginal benefit of avoidance decreases. Tax exhaustion theory suggests that firms expecting
substantial tax benefits from equity compensation will implement fewer additional tax avoidance
strategies. It further suggests that this negative relation is strongest among firms that are nearest
11
to tax exhaustion. For firms facing a lower marginal benefit of tax avoidance, substantial
expected tax benefits from equity compensation more strongly attenuate managers’ demand for
additional tax avoidance. Thus, we state our hypothesis as follows:
When the firm’s marginal benefit of tax avoidance is lower, the relation
between tax avoidance and equity compensation is more negative.
3 Research Design
3.1 Variable Definitions
To maintain consistency and strengthen comparative inferences between results, we model
our research design after Desai and Dharmapala (2006). Therefore, we adopt their variable
construction.
Equity Compensation
We use EXEC_STK to capture the percentage of equity compensation awarded to top
executives during the year. For firm i in year t and each of the top five executives j, we calculate
EXEC_STK as follows:
EXEC_STKi,t =
______ΣOPTIONSi,j,t + _ ΣRSUi,j,t __________
(1)
ΣOPTIONSi,j,t + ΣRSUi,j,t + ΣSALARYi,j,t + ΣBONUSi,j,t
OPTIONS is the fair value of stock options granted to executives during the year, RSU is the fair
value of restricted stock units granted to executives during the year, and SALARY and BONUS
are the amounts of direct (cash) compensation paid to executives during the year. All variables
are from Execucomp.
In our study, EXEC_STK serves as a proxy for both managerial incentive alignment and
the expected tax benefits of equity compensation. Because equity compensation provides tax
deductions in the year of exercise, which is often after the year of grant, we acknowledge that
12
timing differences complicate the effect of current year equity grants on current year tax
avoidance when testing tax exhaustion theory. However, we submit that EXEC_STK is a
reasonable proxy for the expected tax benefits of equity compensation for multiple reasons. First,
Cadman, Rusticus and Sunder (2013) find that over 60 percent of option grants vest within two
years. Therefore, current year option grants are a reasonable proxy for tax benefits expected in
the current year or near future. Second, equity grants are sticky. Thus, firms that previously
recognized tax benefits from equity compensation are likely to expect similar deductions in the
current year. Indeed, in our sample, EXEC_STK is positively correlated with alternative proxies
for the tax benefit of stock-based compensation including options granted to rank-and-file
employees (ρ=0.65) and the value of executives’ option exercises (ρ=0.32) (untabulated).
Finally, Graham et al. (2004) estimate that considering options granted but not yet exercised
reduces the marginal tax rate for S&P 100 firms from 15 percent to 8 percent.
Tax Avoidance
We use TS, developed in Desai and Dharmapala (2006), as our primary measure of tax
avoidance. To calculate TS, we estimate the book-tax gap (BT) as a function of total accruals
(ACC), where BT is the difference between domestic pre-tax book income (PIDOM) and
estimated federal taxable income (USTI=TXFED/0.35), scaled by lagged assets (AT). Because
our sample predates the effective date of SFAS 123R, TS does not reflect the tax benefits of
option exercises. ACC is total accruals defined as in Healy (1985) (-DP-XI+ΔRECT+ΔINVTΔAP-ΔTXP-TXDI). We use ordinary least squares regression and include firm fixed effects to
obtain the following specification:
BTi,t = β1ACCi,t + µi + εi,t.
The firm-specific and firm-year-specific residuals capture tax avoidance:
13
(2)
TS = µi + εi,t,
(3)
where µi captures fixed firm effects and εi,t. represents deviation from µi in each year, t.
Though TS is our primary measure of tax avoidance, we assess the robustness of results
to different proxies for aggressive tax avoidance. TS is intended to isolate the portion of book-tax
differences that is attributable to more intentional and potentially aggressive tax avoidance. To
identify other proxies for aggressive tax avoidance, we follow Lisowsky, Robinson and Schmidt
(2013) and select worldwide book-tax differences (WW_BTD), discretionary tax avoidance
(DTAX) and permanent book-tax differences (PermDiff) computed following Frank, Lynch and
Rego (2009), and a tax shelter prediction score (Shelter) from Wilson (2009). Lisowsky et al.
(2013) classify these proxies as capturing tax aggressiveness and tax sheltering, which we
believe is in line with the types of tax avoidance TS is intended to capture.
Shareholder Rights
The G_Index counts the number of 24 possible anti-takeover provisions that are in place
at the firm such that lower values represent stronger shareholder rights. Desai and Dharmapala
(2006) assume that the ex ante cost of rent extraction is prohibitively high for “well-governed
firms” and classify well-governed firms as those in the bottom quartile of G_Index. In our main
analysis, we follow their definition and set StrongerShareholderRights equal to one for
observations in the bottom quartile of the distribution.
To
assess
the
robustness
of
results
obtained
using
this
definition
of
StrongerShareholderRights, we use the entrenchment index developed by Bebchuk, Cohen and
Farrel (2009) as an alternative measure of shareholder rights. Bebchuk et al. (2009) investigate
which of the 24 provisions included in the G_Index are most important when establishing the
link between shareholder rights and firm value. They isolate six provisions and find that
14
increases in this “Entrenchment” index (E_Index) are monotonically associated with reductions
in firm value and with negative abnormal returns during the 1990s while the other 18 provisions
of the G_Index are uncorrelated with firm value or returns. They conclude that “in a large set of
governance provisions, many are not likely to matter or to be an endogenous product of others.”
Tax Exhaustion
We test tax exhaustion theory as an alternative explanation for the empirical results in
Desai and Dharmapala (2006) by testing whether the marginal benefits of tax avoidance
moderate the relation between equity compensation and tax avoidance. Our first proxy for
nearness to tax exhaustion (i.e., low marginal benefits of tax avoidance) is based on profitability.
Manzon and Plesko (2002) use positive pre-tax income as a proxy for a firm’s demand for tax
minimization activities, noting that, “profitable firms can make efficient use of tax deductions
and credits and benefit from tax exemptions.” Following this logic, we expect the marginal
benefits of tax avoidance are lower for firms experiencing a loss. Therefore, we set BookLoss
equal to one for observations where pre-tax income (PI) is less than or equal to zero.
Our second proxy for nearness to tax exhaustion is extensive R&D expenses (XRD).
R&D activities can provide tax shields in two ways. First, corporations can immediately deduct
R&D expenses for tax purposes though these activities generally do not generate revenues until
future years. Alternatively, firms can claim federal and state R&D credits, which allow them to
reduce their tax liability dollar-for-dollar. Furthermore, the tax benefits of R&D credits are
potentially amplified in the presence of stock options. Brown and Krull (2008) estimate the R&D
tax credits generated by R&D employees’ stock option can be substantial enough to offset
reduced credits due to cuts in R&D spending. HighRD equals one for observations in the top
15
quartile of R&D expense scaled by total assets. When ranking, we assume that firm-years
missing XRD have zero R&D expenses for the year.
Our third proxy for nearness to tax exhaustion is based on the trichotomous marginal tax
rate (MTR) developed in Graham (1996), who shows that an MTR estimated by partitioning
firms according to profitability and the presence of tax loss carryforwards is a reasonable
alternative to using a simulated MTR. 6 Graham (1996) sets the marginal tax rate to (a) the
statutory rate if the observation has positive pre-tax income (PI > 0) and no tax net operating loss
carryforwards (TLCF = 0 or missing), (b) zero if the firm has non-positive pre-tax income (PI ≤
0) and positive tax net operating loss carryforwards (TLCF > 0 or missing), or (c) one-half of the
statutory rate otherwise. We set LowMTR equal to one for observations where the estimated
MTR is less than the statutory rate. Thus, LowMTR equals one if the firm has either PI ≤ 0 or
TLCF > 0. Finally, we define a composite variable, Exhausted, that is equal to one if BookLoss,
HighRD or LowMTR equals one.
3.2 Regression Specification
We estimate the following regressions:
Tax Avoidance = β0 + β1EXEC_STK + Controls +YearEffects +FirmEffects +ε
(4)
Tax Avoidance= β0 + β1 EXEC_STK + β2Moderator +
β3 EXEC_STK *Moderator + Controls +YearEffects +FirmEffects +ε
(5)
Tax Avoidance is TS, WW_BTD, DTAX, PermDiff or Shelter. Moderator is either a proxy for the
cost of rent extraction measured using the relative strength of shareholder rights
(StrongerShareholderRights), or a proxy for nearness to tax exhaustion using either BookLoss,
6
Graham and Mills (2010) obtain similar results using confidential corporate tax return data. Although prior studies
simulate MTRs and make the data publicly available, these MTRs do not reflect the tax benefits from equity
compensation deductions and therefore systematically overstate the MTR for firms with large equity compensation
deductions. Thus, we expect that the omitted effect of these deductions induces considerable noise in the simulated
MTRs in our sample.
16
HighRD, LowMTR, or Exhausted.7 We control for size by including the natural logarithms of
assets (AT), sales (SALE) and market capitalization, where market capitalization is defined as
the closing price at the end of the fiscal year (PRCC_F) multiplied by common shares
outstanding (CSHO). We also control for deferred taxes measured as the total net deferred tax
asset or liability (TXNDB) scaled by lagged assets. If (TXNDB) is missing, our deferred tax
control is deferred taxes from the balance sheet (TXDB) scaled by lagged assets. Finally, we
interact Moderator with each control variable to allow for the possibility that the control
variables differentially affect Tax Avoidance when Moderator equals one.8 We present robust
standard errors clustered by firm in all tables.
The coefficient on EXEC_STK captures the effect of executives’ equity compensation on
tax avoidance. Because the regression specification includes firm and year fixed effects, β1
captures the effect of deviations from the firm- and year-average values of EXEC_STK on Tax
Avoidance. Although neither tax exhaustion theory nor the theory of complementary activities
yields an unambiguous prediction regarding β1, both theories can explain finding β1 <0. In
equation (5), the coefficient on the interaction term EXEC_STK *Moderator (β3) captures the
differential effect of executives’ equity compensation on Tax Avoidance for various subsamples
of interest. This coefficient captures between-firm variation in how deviations from firm- and
year-average values of managers’ incentives affect tax avoidance. We test our hypothesis by
defining Moderator to capture low marginal benefits of tax avoidance such that our hypothesis
7
Desai and Dharmapala (2006) measure G_Index at the firm level, using the score reported in 1998, and so are
unable to include the main effect of shareholder rights in their tests. We collect the value of G_Index that is
concurrent with or closest prior to the fiscal year end, which allows us to include the main effect of
StrongerShareholderRights in our tests. However, results are consistent if we do not include the main effect of
StrongerShareholderRights or if we define shareholder rights using only one year of G_Index.
8
Inferences remain unchanged if we interact Moderator only with EXEC_STK.
17
predicts β3<0. The theory of complementary activities predicts β3>0 when Moderator captures
relatively stronger shareholder rights. We make no prediction on the sign of β2. 9
3.3 Sample
Following Desai and Dharmapala (2006), we construct our sample using observations
from 1993 through 2001 in both Compustat and Execucomp that have non-missing data required
to calculate all variables of interest and control variables. Because TS is estimated using
domestic book-tax differences, observations must have a non-missing value of PIDOM. Most
purely domestic companies do not separately disclose PIDOM because all pre-tax income is
from domestic sources. Therefore, the sample inherently includes only multinational entities. We
further limit our sample to firms with positive estimated federal taxable income to ensure that
firms in our sample have incentives to avoid tax.10 Our primary sample consists of 4,843 firmyear observations from 999 unique firms. The G_Index is available from the Risk Metrics
database for only 3,545 of these observations. Table 1 details our sample selection.
[Insert Table 1 here.]
4 Results
4.1 Descriptive Statistics
In Table 2, we present descriptive statistics. Awards of stock-based compensation
(EXEC_STK) average 44 percent of total executive compensation during the sample period.
As reported in Desai and Dharmapala (2006), we expect β2=0 when Moderator equals StrongerShareholderRights.
When Moderator equals BookLoss or LowMTR, we expect β2<0 because loss firms engage in less tax avoidance and
therefore have smaller book-tax differences. When Moderator equals HighRD the prediction is ambiguous. For
firms deducting R&D expenses on their tax return and in their financial statements, we expect we expect β2 =0. For
firms currently claiming R&D tax credits, we expect β2<0 because estimated taxable income decreases by a larger
amount than pre-tax income as a result of R&D activity. For firms with R&D tax credits generated in the current
period and carried to future periods, we expect β2>0 because estimated taxable income does not reflect the entire
benefit of the credit.
10
Mean (median) USTI is $185M ($36M) in the sub-sample where LowMTR equals one and $94M ($13M) in the
sub-sample of firms where BookLoss equals one. Thus, even these firms facing low marginal benefits of tax
avoidance have not fully exhausted their taxable income and still have an incentive to avoid income tax.
9
18
Firms in our sample report positive accruals-adjusted book-tax differences (TS) at the mean and
median, indicating that pre-tax income exceeds estimated taxable income even after adjusting for
accounting accruals. Similarly, WW_BTD, DTAX and PermDiff are all positive at the mean and
median. Observations in our sample have a strong probability of being involved in a tax shelter.
Approximately seven percent of observations report pre-tax income less than or equal to zero and
almost 32 percent of observations have a low marginal tax rate estimated following Graham
(1996). By construction, we set HighRD equal to one for 25 percent of the sample. The median
firm has nine anti-shareholder/pro-manager provisions in place as measured by Gompers et al.
(2003) and two anti-shareholder/pro-manager provisions in place as measured by the Bebchuk et
al. (2009) entrenchment index. Sample firms are large and profitable with average assets and
market capitalization both exceeding $7B.
[Insert Table 2 here.]
Table 3 presents Pearson and Spearman correlations. We focus on Pearson correlations
in our discussion. Our five proxies for tax avoidance are generally significantly positively
correlated with each other (the exception is DTAX and Shelter, which are uncorrelated). In
untabulated analysis, we find that TS is also very highly correlated with the unadjusted domestic
book-tax gap, BT, which suggests that controlling for the effect of total accruals on BT does not
significantly alter the properties of the measure (ρ=0.9958, p-value<0.001). As expected, TS is
negatively correlated with EXEC_STK. All of our proxies for nearness to tax exhaustion are
positively correlated with each other and with EXEC_STK. This is consistent with firms issuing
equity compensation when the marginal benefits of current deductions is lower to delay the tax
benefits of compensation into future years (e.g., Yermack 1995). G_Index is positively correlated
with TS and Shelter, suggesting firms with more anti-shareholder/pro-manager provisions in
19
place as measured by Gompers et al. (2003) engage in more aggressive tax avoidance as captured
by these two proxies. However, G_Index is uncorrelated with WW_BTD, DTAX and PermDiff.
The two measures of shareholder rights are strongly positively correlated but E_Index is
uncorrelated with TS and with the other proxies for tax avoidance at conventional levels.
[Insert Table 3 here.]
4.2 Tests of tax avoidance and rent extraction as complements
Before testing our hypothesis, we first confirm that we can replicate results presented in
Panel A of Table 3 from Desai and Dharmapala (2006). We present our replication in Table 4.
Consistent with their results, we estimate a significantly negative overall relation between
EXEC_STK and TS in column (1). We further estimate that this negative relation exists only in
the 75% of the sample considered to have relatively weaker shareholder rights (column 2) but
not in the remaining 25% of the sample (column 3). In column (2), we find no association
between EXEC_STK and TS among the 931 observations where StrongerShareholderRights
equals one (coeff. = -0.0123, two-tailed p-value = 0.292). However, in column (3), we estimate a
significantly negative association between EXEC_STK and TS among the 2,614 observations
where StrongerShareholderRights equals zero (coeff. = -0.0196, two-tailed p-value = 0.018). In
column (4), we include the interaction of StrongerShareholderRights and EXEC_STK and
confirm that the relation does not vary significantly between the two groups.
[Insert Table 4 here.]
In Panel B of Table 4, we replace TS with the four alternative proxies for aggressive tax
avoidance. If aggressive tax avoidance and rent extraction are complementary activities, we
would expect to estimate positive coefficients on EXEC_STK*StrongerShareholderRights.
Results across all four columns are not consistent with this prediction. The only statistically
20
significant coefficient we estimate on EXEC_STK*StrongerShareholderRights is in column (2)
when DTAX is the measure of tax avoidance. However, that coefficient is negative and
significant, suggesting that managers of relatively well governed firms engage in significantly
less tax avoidance when their incentives are more aligned with shareholders. This result stands in
direct contract to predictions arising from the model presented in Desai and Dharmapala (2006).
In untabulated analysis, we also estimate the relation separately in each subsample of
firms based on shareholder rights. When WW_BTD or Shelter is the measure of tax avoidance,
we estimate a negative coefficient on EXEC_STK in both groups but it is significant only among
the sample where StrongerShareholderRights equals zero. When DTAX is the measure of tax
avoidance, we estimate a negative coefficient on EXEC_STK in the sample where
StrongerShareholderRights
equals
one
and
a
positive
coefficient
where
StrongerShareholderRights equals zero, but neither are statistically significant at conventional
levels. Finally, when PermDiff is the measure of tax avoidance, we estimate negative coefficients
in both samples but neither are statistically significant. In total, results in Table 4 confirm that
our sample, research design and variable measurement allow us to replicate the main findings
from Desai and Dharmapala (2006). However, they also highlight that the specific pattern of
results therein is sensitive to how tax avoidance is measured.
4.3 Tests of tax exhaustion
Table 5 presents results of testing our hypothesis that the relation between equity
compensation and other forms of tax avoidance is more negative for firms nearer to tax
exhaustion. In column (1), we estimate a negative and significant overall relation between tax
avoidance and equity compensation. This finding is consistent with the tax benefits from option
compensation during the late 1990s and early 2000s being material enough on average to
21
influence firms’ other tax avoidance activities. In columns (2) through (5), we test whether this
overall relation is more negative when firms are nearer to tax exhaustion. Consistent with our
hypothesis, we estimate a significantly negative coefficient on EXEC_STK*TaxExhaustion
across all four columns. In fact, we estimate that there is no statistical relation between equity
compensation and tax avoidance on average, but that the relation only exists for firms nearer to
tax exhaustion. Results in Table 5 support our hypothesis: we estimate that firms closer to tax
exhaustion substitute away from other forms of tax avoidance more than firms that are farther
from exhausting taxable income.
[Insert Table 5 here.]
In Panel B of Table 5 we replace TS with alternative tax avoidance proxies and use our
composite measure, Exhausted, to capture nearness to tax exhaustion. Using these alternative
proxies, we provide some evidence that the relation between equity compensation and tax
avoidance varies as predicted by tax exhaustion theory. Specifically, we estimate a significantly
negative coefficient on EXEC_STK*Exhausted when we measure tax avoidance using either
WW_BTD or PermDiff. We also estimate negative coefficients on EXEC_STK*Exhausted when
we measure tax avoidance using DTAX or Shelter but these coefficients are not significant at
conventional levels using two-tailed p-values (two-tailed p-values are 0.269 when using DTAX
and 0.129 when using Shelter).11 Based on these analyses, we conclude tax exhaustion theory is a
plausible alternative explanation for the negative relation between executives’ equity
compensation and corporate tax avoidance.
11
Even though our hypothesis makes a directional prediction, we assess significance using two-tailed p-values to be
conservative. Using one-tailed p-values, the coefficient on EXEC_STK*Exhausted is significant at the 10 percent
level when we measure tax avoidance using Shelter.
22
5 Re-examining the moderating effect of shareholder rights
We next consider how to reconcile results presented in Table 5, which provide evidence
in support of tax exhaustion theory, with evidence in Table 4 that the negative relation between
equity compensation and tax avoidance exists only in a subset of firms with relatively weaker
shareholder rights. Recent research highlights two features of the Gompers et al. (2003) index
that could limit its usefulness as a measure of shareholder rights broadly as well as in the context
of tax avoidance specifically. We explore the effects of each of these potential limitations below.
5.1 Industry Clustering of Shareholder Rights
Although estimates presented in Table 5 challenge the interpretation of the empirical
results in Desai and Dharmapala (2006) that tax avoidance complements rent extraction, they do
not provide insight into why G_Index and our proxies for tax exhaustion affect the relation
between equity compensation and tax avoidance in a similar manner. To better understand this
pattern of results, we turn to Johnson et al. (2009), who document that some industries are overrepresented in different segments of the distribution of the G_Index. Industry clustering is
problematic in tests of firm performance because it can lead to misspecification (Lyon, Barber
and Tsai 1999). Using well-specified tests to address this industry clustering, Johnson et al.
(2009) find no abnormal returns for hedge portfolios of firms sorted on shareholder rights. Their
results call into question the link between governance, as measured by shareholder rights indices,
and firm value.
Industry clustering of shareholder rights could be similarly problematic in a tax
avoidance setting because tax avoidance opportunities also tend to cluster by industry
(Balakrishnan et al. 2012, De Simone et al. 2015). Thus, results attributed to differences in
shareholder rights could instead be due to differences in tax avoidance opportunities. We explore
23
this conjecture by: (1) identifying industries where tax exhaustion theory predicts the negative
association between tax avoidance and equity compensation should be strongest and (2)
examining whether shareholder rights cluster in these industries.
Our hypothesis predicts the negative relation between equity compensation and tax
avoidance is strongest among firms closest to tax exhaustion. We expect these types of firms are
most likely to be found in high technology industries. Firms in highly technological or
innovative industries are likely to incur substantial amounts of R&D expenditures as they focus
on developing new products to promote future revenue growth. To the extent these expenditures
precede revenues, high technology firms – especially young firms – can incur substantial start-up
losses. Additionally, both finance theory and empirical evidence suggest firms with high growth
opportunities and R&D opportunities award more equity-based compensation to employees (e.g.,
Bizjak, Brickley and Coles 1993, Ryan and Wiggins 2001, Yermack 1995). We therefore expect
high technology firms to be closer to tax exhaustion because they have tax shields in the form of
R&D expenditures, equity-based compensation deductions and/or losses.
In Table 6, we examine whether HighTech firms, identified using the three-digit SIC
classification from Francis and Schipper (1999), are more likely to be tax exhausted than other
firms. Panel A shows the percentage of observations where BookLoss, HighRD, Low_MTR or
Exhausted equals one. In the full sample of observations with non-missing values of G_Index,
roughly seven percent of the observations report a book loss, 22 percent have high levels of
R&D, 32 percent have low marginal tax rates and 46 percent are tax exhausted. The next two
columns of Panel A reveal that a significantly higher proportion of HighTech firms report pre-tax
losses (9.69%) than non-HighTech firms (6.07%). This difference is statistically significant at
one percent using a two-tailed test. A similar pattern emerges for HighRD and LowMTR. We
24
estimate over 61 percent of HighTech firms also report HighRD whereas only nine percent of
non-HighTech firms do. Almost 36 percent of HighTech firms have a low estimated marginal tax
rate compared to only 30 percent for non-HighTech firms. Finally, HighTech firms are
significantly more likely to be tax-exhausted using our composite measure than non-HighTech
firms (72 percent versus 37 percent).
[Insert Table 6 here.]
In Panel B, we examine whether shareholder rights cluster across HighTech or
Exhausted firms following the methodology used in Johnson et al. (2009). We report the
percentage of observations within each score of G_Index that are HighTech (Exhausted) and
compare that to the percentage of observations within the entire sample that are HighTech
(Exhausted). Positive differences indicate HighTech (Exhausted) firms are over-represented
within that particular score of G_Index whereas negative differences indicate they are underrepresented. We report this analysis separately for each value of G_Index that contains at least
100 observations. HighTech firms are over-represented in G_Index scores of six, seven and eight
and largely under-represented in the rest of the distribution. Exhausted firms are significantly
over-represented in G_Index scores of six and seven, and significantly under-represented in
scores of nine, 13 and 14. Thus, high tech firms and tax exhausted firms tend to cluster within
certain values of the G_Index. It is therefore important to consider the effects of both shareholder
rights and nearness to tax exhaustion.
In Panel C, we estimate equation (5) where Moderator equals either HighTech or
Exhausted, and include the continuous value of G_Index as a control. This allows us to test the
effects of both shareholder rights and tax exhaustion. We use the continuous G_Index in these
tests because findings in Panel B of Table 6 suggest that the relation between equity
25
compensation and tax avoidance could be sensitive to the cut-off used to distinguish firms with
relatively weaker or stronger shareholder rights. In column (1), we test whether the relation
between equity compensation and tax avoidance varies across different incremental values of
G_Index and estimate an insignificant coefficient on EXEC_STK*G_Index. In column (2), we
estimate a significant negative coefficient on EXEC_STK*HighTech, consistent with HighTech
firms substituting away from other forms of tax avoidance more than non-HighTech firms when
the
level
of
equity
compensation
is
higher.
In
column
(3),
we
include
both
EXEC_STK*HighTech and EXEC_STK*G_Index to see if the effects of shareholder rights
subsumes the effect of high tech industry membership. We estimate a negative coefficient on
EXEC_STK*HighTech that is marginally significant using two-tailed p-values (coeff = -0.0333,
two-tailed p-value = 0.10). We therefore conclude that after we account for industry clustering
within the distribution of the G_Index and we control for shareholder rights, incremental effects
of tax exhaustion on the relation between equity compensation and tax avoidance remain. We
provide further evidence in support of this assertion in column (4) where we estimate a negative
coefficient on EXEC_STK*Exhausted after controlling for G_Index.12 Results in Table 6 show
that (1) HighTech firms are nearer to tax exhaustion, (2) HighTech and Exhausted firms are not
evenly distributed across values of G_Index and (3) equity compensation and tax avoidance are
negatively related in certain subsamples based on either shareholder rights or tax exhaustion.
Therefore, attributing results to either shareholder rights or tax exhaustion could be problematic
without considering the other effect.
12
Results from estimating the effect of Exhausted on TS, without controlling for shareholder rights are column (5) of
Table 5, Panel A. Inferences from column (4) of Table 6, Panel C remain unchanged if we control for
StrongerShareholderRights and EXEC_STK* StrongerShareholderRights (a binary variable based on relatively
stronger or weaker shareholder rights) rather than a continuous measure of G_Index.
26
5.2 Alternative Cutoff and Measure of Strong Shareholder Rights
Desai and Dharmapala (2006) classify well-governed firms as those with a value of
G_Index less than or equal to 7. Given the clustering of High Tech firms in the middle of the
distribution of the G_Index reported in Panel B of Table 6, we reexamine the relation between
equity compensation and tax avoidance using different cutoff values.
First, we set StrongerShareholderRights equal to one when G_Index ≤ 8. This cutoff
includes all (most) values of the G_Index where High Tech (Exhausted) firms are shown to be
over-represented in Panel B of Table 6. We do not expect including observations with one more
anti-takeover provision to substantially change the governance properties of the sample.
Therefore, the theory of complementary activities continues to suggest a less negative relation in
firms with G_Index ≤ 8. However, this subsample is disproportionately comprised of High Tech
(Exhausted) firms. Thus, tax exhaustion theory predicts the relation should be more negative in
this sample. Columns (1) and (2) of Table 7 show that when G_Index ≤ 8, the estimated
coefficient is -0.0242 (two-tailed p-value = 0.022) and where G_Index > 8, the coefficient is 0.0150 (two-tailed p-value = 0.109). These results are more consistent with tax exhaustion
theory.
Additionally, in columns (3) and (4) we use the E_Index to measure shareholder rights
and bifurcate the sample based on whether the firm has any anti-takeover provisions in place.
Thus, in column (3) we estimate the relation between EXEC_STK and TS where E_Index equals
zero. Managers of these firms are considered the least entrenched. In column (4), we examine the
relation among observations where E_Index > 0. We estimate significantly negative coefficients
on EXEC_STK in both columns. We obtain similar results if we split the sample at the 25th
percentile of E_Index. Thus, it does not appear that the extent of managerial entrenchment
27
measured using the index developed by Bebchuk et al. (2009) has any effect on the relation
between equity compensation and tax avoidance. These results suggest the moderating effect of
shareholder rights on the relation between equity incentives and tax avoidance is also sensitive to
the measure of shareholder rights used.
5.3 Additional Analyses
In untabulated analysis, we gauge the sensitivity of results reported in Panel A of Table 4
to changes in research design. Results are qualitatively unchanged if we replace TS with BT
whether or not we adjust BT for changes in net operating loss carryforwards. With respect to
proxies for managers’ incentives, results are not robust to measuring incentives using Delta as
defined in Core and Guay (2002); we find no association between Delta and TS on average or in
either subsample of firms split based on G_Index. When we measure managers’ incentives with
the combined ownership percentage of the top five executives, we estimate no average effect but
do find evidence of a positive association between ownership and TS only among firms with
weaker shareholder rights. This finding stands in direct contrast to the theory of complementary
activities.
Finally, results in Panel A of Table 4 are not robust to extending the sample period
through 2006.13 We continue to estimate an overall negative relation between TS and EXEC_STK
in this larger sample of 5,448 firm-years. However, in contrast to Panel A of Table 4, we
estimate the negative relation among both subsamples of firms split based on G_Index. Finally, if
we estimate the relation among a subsample of purely domestic firms, for which TS more
accurately captures total tax avoidance, we estimate a significantly more negative relation among
observations where G_Index ≤ 7. We therefore conclude that the pattern of results presented in
13
We stop the analysis in 2006 because the implementation of SFAS 123R, which requires firms to expense equitybased compensation and to reflect the tax benefits of equity-based compensation as a component of taxes from
continuing operations, could affect the construction of TS.
28
Desai and Dharmapala (2006) is sensitive to the sample period, sample construction and measure
of executive incentives.
6 Concluding Remarks
While some studies provide evidence consistent with agency theory predictions that
properly incentivized managers engage in more tax avoidance, others suggest managers use tax
avoidance to extract rents. The primary objective of this paper is to reexamine some of the first
empirical evidence in support of the theory that tax avoidance and rent extraction are
complements. Specifically, we reexamine the negative relation between executives’ equity
compensation and tax avoidance that is concentrated in firms with weaker shareholder rights.
We replicate the overall negative relation between executives’ equity incentives and TS,
but find little evidence of a negative relation using other measures of aggressive tax avoidance.
We also find the relation between executives’ equity incentives and TS is most negative among
firms facing the lowest marginal benefits of tax avoidance, consistent with tax exhaustion theory.
Next, motivated by the findings that shareholder rights cluster by industry (Johnson et al. 2009),
we document that high-technology and tax-exhausted firms cluster within certain values of the
shareholders’ rights indices. We therefore attempt to disentangle the effects of shareholder rights
and tax exhaustion on the relation between executives’ equity compensation and tax avoidance.
After controlling for shareholder rights, we document that the relation is more negative for hightechnology firms and tax-exhausted firms, but does not differ with shareholder rights. Finally, we
document that the moderating effect of shareholder rights is sensitive to the cut-off selected to
identify firms with relatively stronger shareholder rights and to the measure of shareholder rights
used. Our results challenge the notion that the empirical findings in Desai and Dharmapala
(2006) reflect managers’ use of tax avoidance to facilitate rent extraction.
29
References
Armstrong, C., J. Blouin, A. Jagolinzer, and D. Larcker, 2015. Corporate governance, incentives
and tax avoidance. Journal of Accounting and Economics 60, 1-17.
Armstrong, C., J. Blouin, and D. Larcker, 2012. The incentives for tax planning. Journal of
Accounting and Economics 53, 391-411.
Babenko, I. and Y. Tserlukevich, 2009. Analyzing the tax benefits from employee
stock options. The Journal of Finance 64, 1797-1825.
Balakrishnan, K., J. Blouin and W. Guay, 2012. Does tax aggressiveness reduce corporate
transparency? Working paper, University of Pennsylvania.
Bebchuk, L., Cohen, and A. Ferrell, 2009. What matters in corporate governance? Review of
Financial Studies 22, 783-827.
Bizjak, J., J. Brickley, and J. Coles, 1993. Stock-based incentive compensation and investment
behavior. Journal of Accounting and Economics 16, 349-372.
Blaylock, B., 2015. Is tax avoidance associated with economically significant rent extraction
among U.S. firms? Contemporary Accounting Research 33, 1013-1043.
Brown, J. and L. Krull, 2008. Stock options, R&D and the R&D tax credit. The Accounting
Review 83, 705-734.
Cadman, B., T. Rusticus and J. Sunder, 2013. Stock option grant vesting terms: Economic and
financial determinants. Review of Accounting Studies 18, 1159-1190.
Chen, S., X. Chen, Q. Cheng, and T. Shevlin, 2010. Are family firms more tax aggressive than
non-family firms? Journal of Financial Economics. 95, 41-61.
Core, J. E. and W. R. Guay, 2002. Estimating the value of employee stock option portfolios and
their sensitivities to price and volatility. Journal of Accounting Research 40, 613-630.
Crocker, K. and J. Slemrod, 2005. Corporate tax evasion with agency costs. Journal of Public
Economics 89, 1593-1610.
DeAngelo, H., and R. Masulis, 1980. Optimal capital structure under corporate and personal
taxation. Journal of Financial Economics 8, 3-29.
Desai, M., and D. Dharmapala, 2006. Corporate tax avoidance and high-powered incentives.
Journal of Financial Economics 79, 145-179.
Desai, M. and D. Dharmapala, 2009. Corporate tax avoidance and firm value. Review of
Economics and Statistics 91, 537-546.
Desai, M., A. Dyck and L. Zingales, 2007. Theft and taxes. Journal of Financial Economics 84,
591-623.
De Simone, L., L. Mills and B. Stomberg. 2015. Examining IRS outcomes of income mobile
firms. Working paper, Stanford University, University of Texas and University of Georgia.
Francis, J. and K. Schipper, 1999. Have financial statements lost their relevance? Journal of
Accounting Research 37, 319-352.
Gaertner, F., 2014. CEO after-tax compensation incentives and corporate tax avoidance.
Contemporary Accounting Research 31, 1077-1102.
Gompers, P., J. Ishii, and A. Metrick, 2003. Corporate governance and equity prices. Quarterly
Journal of Economics 118, 107-155.
Graham, J. R., 1996. Proxies for the corporate marginal tax rate. Journal of Financial Economics
42, 187-221.
Graham, J., M. Lang, and D. Shackelford, 2004. Employee stock options, corporate taxes, and
debt policy. Journal of Finance 59, 1585-1618.
30
Graham, J., and L. Mills, 2010. Using tax return data to simulate corporate marginal tax rates.
Journal of Accounting and Economics 46, 366-388.
Graham, J., and A. Tucker, 2006. Tax shelters and corporate debt policy. Journal of Financial
Economics 81, 563-594.
Hanlon, M., L. Mills, and J. Slemrod, 2007. An empirical examination of corporate tax
noncompliance. In A. Auerbach, J. R. Hines Jr. and J. Slemrod (Eds.), Taxing Corporate
Income in the 21st Century. Cambridge University Press, New York City, NY, pp. 171-210.
Hanlon, M., and T. Shevlin, 2002. Accounting for tax benefits of employee stock options and
implications for research. Accounting Horizons 16, 1-16.
Hasan, I., C. Hoi, Q. Wu, and H. Zhang, 2014. Beauty is in the eye of the beholder: The effect of
corporate tax avoidance on the cost of bank loans. Journal of Financial Economics 113, 109130.
Healy, P., 1985. The effect of bonus schemes on accounting decision. Journal of Accounting and
Economics 7, 85-107.
Johnson, S., T. Moorman and S. Sorescu, 2009. A reexamination of corporate governance and
equity prices. Review of Financial Studies 22, 4753-4786.
Kim, J., Y. Li, and L. Zhang, 2011. Corporate tax avoidance and stock price crash risk: Firmlevel analyses. Journal of Financial Economics 100, 630-662.
Lennox, C., P. Lisowsky, and J. Pittman, 2013. Tax aggressiveness and accounting fraud.
Journal of Accounting Research 41, 739-778.
Lisowsky, P., L. Robinson and A. Schmidt, 2013. Do publicly disclosed tax reserves tell us about
privately disclosed tax shelter activity? Journal of Accounting Research 51, 583-629.
Lyon, J., M. Barber and C. Tsai, 1999. Improved methods for tests of long-run abnormal stock
returns. Journal of Finance 54, 165-201.
MacKie-Mason, J., 1990. Do taxes affect corporate financing decisions? Journal of Finance 45,
1471-1493.
Manzon Jr., G., and G. Plesko, 2002. The Relation between financial and tax reporting measures
of income. New York University School of Law Tax Law Review 55, 175-214.
Phillips, J., 2003. Corporate Tax-Planning Effectiveness: The role of compensation-based
incentives. The Accounting Review 78, 847-874.
Powers, K., J. Robinson and B. Stomberg, 2016. How do CEO incentives affect corporate tax
planning and financial reporting of income taxes? Review of Accounting Studies 21, 672-710.
Rego, S., and R. Wilson, 2012. Equity risk incentives, and corporate tax aggressiveness. Journal
of Accounting Research 50, 775-810.
Robinson, J., S. Sikes, and C. Weaver, 2010. Performance measurement of corporate tax
departments. The Accounting Review 85, 1035-1064.
Ryan, H. E., and R. A Wiggins III, 2001. The influence of firm- and manager-specific
characteristics on the structure of executive compensation.” Journal of Corporate Finance 7,
101-123.
Wilson, R., 2009. An examination of corporate tax shelter participants. The Accounting Review
84, 969-999.
Yermack, D., 1995. Do corporations award CEO stock options effectively? Journal of Financial
Economics 39, 237-269.
31
Table 1
Sample Selection
US firm-years from 1993-2001: Intersection of Compustat and Execucomp
Less: Observations missing EXEC_STK
Less: Observations with insufficient data to calculate BT
Less: Observations with USTI≤0
Less: Observations with insufficient data to calculate controls
Primary Sample
Less: Observations missing G_Index from Risk Metrics
Sample for tests of shareholder rights
17,919
(1,554)
(10,449)
(995)
(78)
4,843
(1,298)
3,545
EXEC_STK is the ratio of options and restricted stock granted in year t to the top five executives to salary, bonus,
options and restricted stock granted to the top five executives in year t. BT is domestic pre-tax income less estimated
US taxable income, scaled by lagged assets. [PIDOMt-(TXFEDt/0.35)]/ATt-1. USTI is estimated US taxable income
(TXFED/0.35). We restrict the sample to observations where estimated taxable income is positive so that all
observations come from firm-years in which managers had incentives to further reduce taxable income. G_Index is
the shareholder rights index from Gompers, Ishii and Metrick (2003).
32
EXEC_STK
Tax Avoidance Proxies
TS
WW_BTD
DTAX
PermDiff
Shelter
Moderators
Book Loss
HighR&D
Low MTR
Exhausted
G_Index
E_Index
Control Variables
LN(Assets)
LN(Sales)
LN(Market Cap)
Deferred Taxes
Other Characteristics
BT
ACC
Assets
Sales
Market Cap
Table 2
Descriptive Statistics
N
Mean
Std Dev
4,843
0.438
0.263
P25
0.243
P50
0.434
P75
0.644
4,843
4,787
4,320
4,834
4,433
0.003
0.005
0.013
0.008
0.918
0.087
0.092
0.384
0.049
0.099
-0.013
-0.012
-0.012
-0.003
0.893
0.008
0.011
0.016
0.006
0.948
0.029
0.036
0.073
0.020
0.978
4,843
4,843
4,843
4,843
3,545
3,545
0.070
0.250
0.317
0.480
9.471
1.960
0.256
0.433
0.465
0.500
2.808
1.193
0.000
0.000
0.000
0.000
7.000
1.000
0.000
0.000
0.000
0.000
9.000
2.000
0.000
1.000
1.000
1.000
12.00
3.000
4,843
4,843
4,843
4,843
21.07
21.07
21.26
0.010
1.614
1.517
1.569
0.063
19.88
19.97
20.09
-0.010
20.90
20.96
21.09
0.007
22.10
22.08
22.27
0.037
4,843
4,843
4,843
4,843
4,843
0.004
-0.017
7,328
4,872
7,259
0.087
0.120
33,425
13,235
24,108
-0.011
-0.067
430.8
469.5
532.3
0.009
-0.033
1,192
1,262
1,442
0.031
0.012
3,952
3,888
4,677
EXEC_STK is the ratio of options and restricted stock granted in year t to the top five executives to salary, bonus,
options and restricted stock granted to the top five executives in year t. TS is the residual from a regression of booktax differences ([PIDOMt-(TXFEDt/0.35)]/ATt-1) on total accruals measured following Healy (1985). WW_BTD is
worldwide book-tax differences ([PIt-(TXFEDt + TXFOt)/0.35]/ATt-1). DTAX and PermDiff are computed following
Frank, Lynch and Rego (2009). Shelter is the tax shelter prediction score from Wilson (2009). BookLoss is an
indicator variable equal to one if PI ≤ 0. HighRD is an indicator variable equal to one if R&D expenses scaled by
total assets (XRDt/ATt) is in the top quartile of the sample. LowMTR is an indicator variable equal to one if both PI t
≤ 0 and TLCFt >0 following Graham (1996). Exhausted is an indicator variable equal to one if BookLoss, HighRD
or LowMTR equals one. G_Index is the shareholder rights index from Gompers, Ishii and Metrick (2003). E_Index is
the entrenchment index from Bebchuk, Cohen and Ferrell (2009). LN(Assets) is the natural log of Assets (ATt).
LN(Sales) is the natural log of Sales (SALEt). LN(MarketCap) is the natural log of Market Cap (PRCC_Ft*CSHOt).
Deferred Taxes is deferred income taxes on the balance sheet scaled by lagged assets (TXNDB t)/(ATt-1); if TXNDB
is missing, Deferred Taxes equals (TXDBt)/(ATt-1). BT is domestic book-tax differences ([PIDOMt(TXFEDt)/0.35]/ATt-1) and ACC is total accruals calculated following Healy (1985).
33
Table 3
Correlations
(1)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
TS
WW_BTD
DTAX
PermDiff
Shelter
EXEC_STK
Book Loss
High R&D
Low mTR
Exhausted
G_Index
E_Index
0.819
0.122
0.546
0.184
-0.072
-0.367
-0.028
-0.185
-0.131
0.036
0.024
(2)
0.935
0.158
0.328
0.272
-0.028
-0.399
0.010
-0.185
-0.104
0.000
-0.016
(3)
0.076
0.085
0.149
0.036
0.078
-0.042
0.101
0.053
0.102
-0.029
-0.004
(4)
0.643
0.553
0.103
0.087
-0.052
-0.253
0.159
-0.161
0.003
-0.006
-0.014
(5)
0.248
0.312
0.005
0.264
0.314
-0.223
0.068
-0.057
0.015
0.057
-0.068
(6)
-0.091
-0.072
-0.026
-0.053
0.195
0.085
0.230
0.099
0.189
-0.055
-0.033
(7)
-0.388
-0.431
-0.016
-0.329
-0.361
0.086
0.069
0.355
0.286
-0.032
0.011
(8)
-0.057
-0.041
-0.031
0.075
0.012
0.230
0.069
0.060
0.601
-0.209
-0.133
(9)
-0.170
-0.185
-0.004
-0.164
-0.117
0.098
0.355
0.060
0.709
-0.004
0.040
(10)
-0.110
-0.113
-0.001
-0.020
-0.055
0.188
0.286
0.601
0.709
-0.107
-0.039
(11)
0.038
0.021
0.011
0.015
0.068
-0.048
-0.032
-0.209
-0.005
-0.111
(12)
0.025
-0.002
-0.001
0.000
-0.014
-0.027
0.010
-0.132
0.039
-0.041
0.740
0.741
Pearson (Spearman) correlations above (below) the diagonal. Correlations that are significant at 10% or less are bold. TS is the residual from a regression of book-tax
differences ([PIDOMt-(TXFEDt/0.35)]/ATt-1) on total accruals measured following Healy (1985). WW_BTD is worldwide book-tax differences ([PIt-(TXFEDt +
TXFOt)/0.35]/ATt-1). DTAX and PermDiff are computed following Frank, Lynch and Rego (2009). Shelter is the tax shelter prediction score from Wilson (2009).
EXEC_STK is the ratio of options and restricted stock granted in year t to the top five executives to salary, bonus, options and restricted stock granted to the top five
executives in year t. BookLoss is an indicator variable equal to one if PI ≤ 0. HighRD is an indicator variable equal to one if R&D expenses scaled by total assets
(XRDt/ATt) is in the top quartile of the sample. LowMTR is an indicator variable equal to one if both PIt ≤ 0 and TLCFt > 0 following Graham (1996). Exhausted is an
indicator variable equal to one if BookLoss, HighRD or LowMTR equals one. G_Index is the shareholder rights index from Gompers, Ishii and Metrick (2003). E_Index
is the entrenchment index from Bebchuk, Cohen and Ferrell (2009).
34
Table 4
Tests of Tax Avoidance and Rent Extraction as Complements
Panel A examines how shareholder rights affect the relation between executives’ equity
compensation and tax avoidance, which is measured using TS:
TS = β0 + β1EXEC_STK + β2StrongerShareholderRights+
β3 EXEC_STK * StrongerShareholderRights + Controls +YearEffects +FirmEffects +ε
EXEC_STK
pred
?
All Firms
G_Index ≤ 7 G_Index > 7
(1)
(2)
(3)
-0.0193 ***
-0.0123
-0.0196 **
(0.007)
(0.012)
(0.008)
All Firms
(4)
-0.0193 **
(0.008)
StrongerShareholderRights
?
-0.1035
(0.159)
EXEC_STK *StrongerShareholderRights
+
0.0045
(0.014)
LN(Assets)
-0.0151
(0.017)
-0.0110
(0.032)
-0.0130
(0.020)
-0.0143
(0.018)
LN(Sales)
-0.0177
(0.016)
-0.0459
(0.039)
-0.0124
(0.019)
-0.0193
(0.017)
LN(Market Cap)
0.0276 ***
(0.005)
0.0303 ***
(0.011)
0.0274 ***
(0.005)
0.0268 ***
(0.005)
Deferred Taxes
-0.2983 **
(0.141)
-0.6078 **
(0.261)
-0.1993
(0.171)
-0.2371
(0.159)
Observations
3,545
931
2,614
3,545
R-squared
44.2%
50.6%
46.0%
44.9%
TS is the residual from a regression of book-tax differences [PIDOMt-(TXFEDt/0.35)]/ATt-1 on total accruals
measured following Healy (1985). EXEC_STK is the ratio of options and restricted stock granted in year t to the top
five executives to salary, bonus, options and restricted stock granted to the top five executives in year t.
StrongerShareholderRights is an indicator variable equal to one if G_Index ≤ 7. LN(Assets), the natural log of Assets
(ATt); LN(Sales), the natural log of Sales (SALEt); LN(MarketCap), the natural log of Market Cap
(PRCC_Ft*CSHOt); Deferred Taxes, deferred income taxes on the balance sheet scaled by lagged assets
(TXNDBt)/(ATt-1); if TXNDB is missing, Deferred Taxes equals
(TXDBt)/(ATt-1). Additionally,
StrongerShareholderRights is interacted with all control variables. Year and firm fixed effects are included. All
continuous variables are winsorized at 1 and 99 percent. ***, **, * represents significance at the 1%, 5% or 10%
level using two-tailed p-values.
35
Table 4 (cont’d)
Tests of Tax Avoidance and Rent Extraction as Complements
Panel B examines how shareholder rights affect the relation between executives’ equity
compensation and tax avoidance measured using alternative measures of tax avoidance:
Tax Avoidance = β0 + β1EXEC_STK + β2StrongerShareholderRights+
β3 EXEC_STK * StrongerShareholderRights + Controls +YearEffects +FirmEffects +ε
Tax Avoidance =
pred
WW_BTD
(1)
DTAX
(2)
PermDiff
(3)
Shelter
(4)
EXEC_STK
?
-0.0231 ***
(0.009)
0.0721
(0.081)
-0.0055
(0.006)
-0.0153 *
(0.009)
StrongerShareholderRights
?
-0.1296
(0.185)
-1.0688
(0.917)
0.0186
(0.098)
0.0563
(0.194)
EXEC_STK *StrongerShareholderRights
+
0.0005
(0.016)
-0.1860
(0.107)
0.0019
(0.010)
-0.0006
(0.018)
LN(Assets)
-0.028
(0.019)
0.2296
(0.086)
*** -0.0050
(0.008)
0.0200
(0.017)
LN(Sales)
-0.0069
(0.018)
-0.2648 *** -0.0146
(0.086)
(0.008)
LN(Market Cap)
0.0325
(0.005)
Deferred Taxes
-0.2834
(0.167)
*** -0.0149
(0.026)
*
1.4832
(1.011)
*
*
-0.0052
(0.016)
0.0184
(0.004)
***
0.0384
(0.008)
0.0996
(0.051)
*
0.0248
(0.062)
***
Observations
3,494
3,221
3,541
3,396
R-squared
46.7%
30.6%
49.1%
70.8%
WW_BTD is worldwide book-tax differences ([PIt-(TXFEDt + TXFOt/0.35)]/ATt-1). DTAX and PermDiff are
computed following Frank, Lynch and Rego (2009). Shelter is the tax shelter prediction score from Wilson (2009).
EXEC_STK is the ratio of options and restricted stock granted in year t to the top five executives to salary, bonus,
options and restricted stock granted to the top five executives in year t. StrongerShareholderRights is an indicator
variable equal to one if G_Index ≤ 7. LN(Assets), the natural log of Assets (ATt); LN(Sales), the natural log of Sales
(SALEt); LN(MarketCap), the natural log of Market Cap (PRCC_Ft*CSHOt); Deferred Taxes, deferred income taxes
on the balance sheet scaled by lagged assets (TXNDBt)/(ATt-1); if TXNDB is missing, Deferred Taxes equals
(TXDBt)/(ATt-1). Additionally, StrongerShareholderRights is interacted with all control variables. Year and firm
fixed effects are included. All continuous variables are winsorized at 1 and 99 percent. ***, **, * represents
significance at the 1%, 5% or 10% level using two-tailed p-values.
36
Table 5
Testing Tax Exhaustion Theory
Panel A examines how tax exhaustion moderates the relation between executives’ equity
compensation and tax avoidance, which is measured using TS:
TS = β0 + β1EXEC_STK + β2TaxExhaustion+
β3 EXEC_STK * TaxExahustion + Controls +YearEffects +FirmEffects +ε
TaxExhaustion=
EXEC_STK
pred
?
None
BookLoss=1
(1)
(2)
-0.0216 ***
-0.0007
(0.007)
(0.005)
High_R&D=1
(3)
-0.0067
(0.006)
Low_MTR=1
(4)
-0.0024
(0.006)
Exhausted=1
(5)
0.0020
(0.006)
TaxExhaustion
-
-0.4648 ***
(0.141)
0.0235
(0.141)
-0.3077 ***
(0.075)
-0.1481 ***
(0.068)
EXEC_STK*TaxExhaustion
-
-0.0890 **
(0.041)
-0.0466 **
(0.020)
-0.0528 ***
(0.017)
-0.0425 ***
(0.014)
LN(Assets)
-0.0273 **
(0.013)
-0.0122
(0.011)
-0.0239 **
(0.011)
-0.0138
(0.009)
-0.0143
(0.009)
LN(Sales)
-0.0112
(0.013)
-0.0174
(0.011)
-0.0090
(0.011)
-0.0174 *
(0.010)
-0.0132
(0.010)
LN(Market Cap)
0.0261 ***
(0.004)
0.0124 ***
(0.004)
0.0216 ***
(0.004)
0.0147 ***
(0.004)
0.0107 ***
(0.003)
Deferred Taxes
-0.2732 ***
(0.095)
-0.2402 ***
(0.093)
-0.2549 ***
(0.052)
-0.2584 ***
(0.084)
-0.1922 ***
(0.065)
Observations
R-squared
4,843
60.4%
4,843
66.7%
4,843
61.1%
4,843
63.1%
4,843
61.8%
TS is the residual from a regression of book-tax differences [PIDOMt-(TXFEDt/0.35)]/ATt-1 on total accruals measured
following Healy (1985). EXEC_STK is the ratio of options and restricted stock granted in year t to the top five executives
to salary, bonus, options and restricted stock granted to the top five executives in year t. TaxExhaustion is either: (1)
BookLoss, an indicator variable equal to one if PI ≤ 0, (2) HighRD, an indicator variable equal to one if R&D expenses
scaled by total assets (XRDt/ATt) is in the top quartile of the sample, or (3) LowMTR, an indicator variable equal to one if
both PIt ≤ 0 and TLCFt > 0 following Graham (1996). Exhausted is an indicator variable equal to one if either BookLoss,
HighRD or LowMTR equals one. LN(Assets), the natural log of Assets (ATt); LN(Sales), the natural log of Sales (SALEt);
LN(MarketCap), the natural log of Market Cap (PRCC_Ft*CSHOt); Deferred Taxes, deferred income taxes on the balance
sheet scaled by lagged assets (TXNDBt)/(ATt-1); if TXNDB is missing, Deferred Taxes equals (TXDBt)/(ATt-1).
Additionally, TaxExhaustion is interacted with all control variables. Year and firm fixed effects are included. All
continuous variables are winsorized at 1 and 99 percent. ***, **, * represents significance at the 1%, 5% or 10% level
using two-tailed p-values.
37
Table 5 (cont’d)
Testing Tax Exhaustion Theory
Panel B examines how tax exhaustion moderates the relation between executives’ equity
compensation and tax avoidance measured using alternative measures of tax avoidance:
Tax Avoidance = β0 + β1EXEC_STK + β2Exhausted+
β3 EXEC_STK * Exhausted + Controls +YearEffects +FirmEffects +ε
TaxAvoidance =
pred
WW_BTD
(1)
DTAX
(2)
EXEC_STK
?
0.0009
(0.006)
Exhausted
?
-0.2052
(0.086)
EXEC_STK*Exhausted
-
-0.0446 *** -0.0931
(0.015)
(0.084)
LN(Assets)
-0.0253
(0.010)
LN(Sales)
**
**
PermDiff
(3)
0.0593
(0.063)
0.0049
(0.003)
0.2795
(0.256)
-0.1051
(0.045)
0.0040
(0.007)
**
-0.3732 ***
(0.106)
-0.0247 ***
(0.008)
-0.022
(0.014)
0.0072
(0.011)
0.1542
(0.070)
**
-0.0116
(0.006)
-0.0024
(0.010)
-0.1619
(0.072)
**
-0.0077
(0.006)
LN(Market Cap)
0.0151
(0.004)
*** -0.0273
(0.026)
Deferred Taxes
-0.2139 ***
(0.072)
0.4725
(0.330)
Shelter
(4)
**
0.0084
(0.011)
0.0092
(0.002)
***
0.0289
(0.006)
0.0705
(0.032)
**
-0.0023
(0.051)
***
Observations
4,787
4,320
4,834
4,433
R-squared
60.8%
30.0%
49.6%
71.0%
WW_BTD is worldwide book-tax differences ([PIDOMt-(TXFEDt + TXFOt)/0.35]/ATt-1). DTAX and PermDiff are
computed following Frank, Lynch and Rego (2009). Shelter is the tax shelter prediction score from Wilson (2009).
EXEC_STK is the ratio of options and restricted stock granted in year t to the top five executives to salary, bonus,
options and restricted stock granted to the top five executives in year t. Exhausted is an indicator variable equal to
one if BookLoss, HighRD or LowMTR is equal to one. BookLoss is an indicator variable equal to one if PI ≤ 0.
HighRD is an indicator variable equal to one if R&D expenses scaled by total assets (XRD t/ATt) is in the top
quartile of the full sample of 4,843 observations. LowMTR is an indicator variable equal to one if both PI t ≤ 0 and
TLCFt > 0 following Graham (1996). LN(Assets), the natural log of Assets (ATt); LN(Sales), the natural log of Sales
(SALEt); LN(MarketCap), the natural log of Market Cap (PRCC_Ft*CSHOt); Deferred Taxes, deferred income
taxes on the balance sheet scaled by lagged assets (TXNDB t)/(ATt-1); if TXNDB is missing, Deferred Taxes equals
(TXDBt)/(ATt-1). Additionally, Exhaused is interacted with all control variables. Year and firm fixed effects are
included. All continuous variables are winsorized at 1 and 99 percent. ***, **, * represents significance at the 1%,
5% or 10% level using two-tailed p-values.
38
Table 6
Tax Exhaustion and Shareholder Rights
Panel A: Tax exhaustion for high-technology firms
% Full Sample
6.97%
21.95%
31.54%
45.87%
BookLoss
HighRD
LowMTR
Exhausted
HighTech=0
6.07%
9.03%
30.17%
37.22%
HighTech=1
9.69%***
61.23%***
35.69%***
72.18%***
Panel A shows mean values of BookLoss, HighRD, LowMTR and Exhausted. BookLoss is an indicator variable equal
to one if PI ≤ 0. HighRD is an indicator variable equal to one if R&D expenses scaled by total assets (XRDt/ATt) is
in the top quartile of the full sample of 4,843 observations. LowMTR is an indicator variable equal to one if both PI t
≤ 0 and TLCFt > 0 following Graham (1996). Exhausted is an indicator variable equal to one if BookLoss, HighRD
or LowMTR is equal to one. The first column presents the mean for the sample of 3,545 observations where G_Index
is not missing. The second (third) column presents the mean for the subsample where HighTech equals zero (one).
HighTech is an indicator variable equal to one if the firm is in one of the following three-digit SIC codes from
Francis and Schipper (1999): 283, 357, 360-368, 481, 737, and 873. ***, **, * represents significance differences in
means at 1%, 5% or 10% level using two-tailed p-values.
Panel B: Shareholder rights for high-technology and tax-exhausted firms
Diff. vs. Full
G_Index No. Obs. % HighTech
Sample
% Exhausted
5
186
23.66%
-1.08%
51.61%
6
294
42.52%
17.78% ***
52.72%
7
333
40.84%
16.10% ***
52.25%
8
389
37.53%
12.79% ***
49.61%
9
453
20.31%
-4.43% ***
41.72%
10
425
18.59%
-6.15% ***
45.88%
11
412
19.42%
-5.32% ***
48.06%
12
377
14.85%
-9.88% ***
45.36%
13
303
18.81%
-5.93% ***
36.96%
14
163
5.52%
-19.22% ***
28.22%
Other
210
25.24%
0.50%
46.19%
Full Sample
3,545
24.74%
N/A
45.87%
Diff. vs. Full
Sample
5.75%
6.85% ***
6.38% ***
3.75%
-4.15% *
0.01%
2.19%
-0.51%
-8.90% ***
-17.65% ***
0.32%
N/A
G_Index is the shareholder rights index from Gompers, Ishii and Metrick (2003). HighTech is an indicator variable
equal to one if the firm is in one of the following three-digit SIC codes from Francis and Schipper (1999): 283, 357,
360-368, 481, 737, and 873. Exhausted is an indicator variable equal to one if BookLoss, HighRD or LowMTR is
equal to one. BookLoss is an indicator variable equal to one if PI ≤ 0. HighRD is an indicator variable equal to one if
R&D expenses scaled by total assets (XRDt/ATt) is in the top quartile of the full sample of 4,843 observations.
LowMTR is an indicator variable equal to one if both PI t ≤ 0 and TLCFt > 0 following Graham (1996). ***, **, *
represents significance differences in means versus the full sample at 1%, 5% or 10% level using two-tailed pvalues.
39
Table 6 (cont’d.)
Tax Exhaustion and Shareholder Rights
Panel C estimates TS as a function of executives’ equity compensation, shareholder rights and
nearness to tax exhaustion:
(3)
-0.0175
(0.021)
(4)
-0.0037
(0.020)
0.0023
(0.002)
0.0025
(0.002)
0.0028
(0.002)
0.0009
(0.002)
0.0008
(0.002)
0.0007
(0.002)
pred
?
(1)
-0.0277
(0.020)
G_Index
?
EXEC_STK*G_Index
+
EXEC_STK*High Technology
-
EXEC_STK
Exhausted
EXEC_STK*Exhausted
Observations
R-squared
(2)
-0.0098
(0.007)
-0.0342 *
(0.020)
-0.0333
(0.020)
?
-0.1975 **
(0.084)
-
-0.0403 ***
(0.014)
3,545
44.3%
3,545
45.1%
3,545
45.1%
3,545
46.7%
TS is the residual from a regression of BT on ACC where BT is pre-tax income less estimated US taxable income,
scaled by lagged assets. [PIDOMt-(TXFEDt/0.35)]/ATt-1 and ACC is total accruals measured following Healy
(1985). EXEC_STK is the ratio of options and restricted stock granted in year t to the top five executives to salary,
bonus, options and restricted stock granted to the top five executives in year t. G_Index is the shareholder rights
index from Gompers, Ishii and Metrick (2003) HighTech is an indicator variable equal to one if the firm is in one of
the following three-digit SIC codes from Francis and Schipper (1999): 283, 357, 360-368, 481, 737, and 873.
Exhausted is an indicator variable equal to one if BookLoss, HighRD or LowMTR is equal to one. BookLoss is an
indicator variable equal to one if PI ≤ 0. HighRD is an indicator variable equal to one if R&D expenses scaled by
total assets (XRDt/ATt) is in the top quartile of the full sample of 4,843 observations. LowMTR is an indicator
variable equal to one if both PIt ≤ 0 and TLCFt > 0 following Graham (1996). The following control variables are
included but not tabulated for parsimony: LN(Assets), the natural log of Assets (ATt); LN(Sales), the natural log of
Sales (SALEt); LN(MarketCap), the natural log of Market Cap (PRCC_Ft*CSHOt); Deferred Taxes, deferred
income taxes on the balance sheet scaled by lagged assets (TXNDB t)/(ATt-1); if TXNDB is missing, Deferred Taxes
equals (TXDBt)/(ATt-1). Additionally, HighTech (Exhausted) is interacted with all control variables. Year and firm
fixed effects are included. Because HighTech does not vary by firm, we cannot include it as a variable of interest.
Year and firm fixed effects are included. All continuous variables are winsorized at 1 and 99 percent. ***, **, *
represents significance at the 1%, 5% or 10% level using two-tailed p-values.
40
Table 7
Revisiting the Effect of Shareholder Rights
Table 7 estimates tax avoidance as a function of executives’ equity compensation and controls
using different cutoffs of G_Index and E_Index:
TS = β0 + β1EXEC_STK + Controls +YearEffects +FirmEffects +ε
Sample =
EXEC_STK
Observations
R-squared
G_Index ≤ 8
(1)
-0.0242 **
(0.010)
1,320
51.3%
G_Index > 8
(2)
-0.0150
(0.009)
2,255
45.5%
E_Index=0
(3)
-0.0280
**
(0.0140)
508
54.7%
E_Index>0
(4)
-0.0184
**
(0.0078)
3,037
44.9%
TS is the residual from a regression of BT on ACC where BT is pre-tax income less estimated US taxable income,
scaled by lagged assets. [PIDOMt-(TXFEDt/0.35)]/ATt-1 and ACC is total accruals measured following Healy
(1985). EXEC_STK is the ratio of options and restricted stock granted in year t to the top five executives to salary,
bonus, options and restricted stock granted to the top five executives in year t. G_Index is the shareholder rights
index from Gompers, Ishii and Metrick (2003). E_Index is the entrenchment index from Bebchuk, Cohen and Ferrell
(2009). The following control variables are included but not tabulated for parsimony: LN(Assets), the natural log of
Assets (ATt); LN(Sales), the natural log of Sales (SALEt); LN(MarketCap), the natural log of Market Cap
(PRCC_Ft*CSHOt); Deferred Taxes, deferred income taxes on the balace sheet scaled by lagged assets
(TXNDBt)/(ATt-1); if TXNDB is missing, Deferred Taxes equals (TXDBt)/(ATt-1). Year and firm fixed effects are
included. All continuous variables are winsorized at 1 and 99 percent. ***, **, * represents significance at the 1%,
5% or 10% level using two-tailed p-values.
41