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Tax Avoidance, Corporate Governance
and Firm Value
Jingjing Chen1
This paper examines whether corporate governance regulates the influence of tax
avoidance on firm value and how this influence affects the valuation of shareholders.
Taking the data of FTSE 350 firms on London Stock Exchange from 2008 to 2015 as
the sample, the empirical results show evidence that the effect of tax avoidance is
positive on firm value for firms with strong corporate governance and insignificant for
firms with weak corporate governance. Among the corporate governance techniques,
compensation incentives and board structure appear to have impacts on corporate tax
avoidance and other proxies of corporate governance show no statistical significance
on tax avoidance measures. As shown in the findings, the relationship between
corporate tax avoidance and firm value is found to be conditional to corporate
governance at disaggregate level and the overall effect of corporate governance on the
relationship is insignificant.
Keywords: Tax Avoidance; Corporate Governance; Firm Value; Agency theory;
1 Jingjing Chen ([email protected]) is a PhD student of Finance and Management Science Department, Carson College of Business, Washington State University in Pullman, WA.
1. Introduction
This study aims to examine the relationship between tax avoidance, corporate
governance and firm value in a sample of UK companies. The research puts forward
two fundamental questions, how shareholders consider the value of corporate tax
avoidance activities, and to what extent corporate governance affects the shareholder’s
valuation on tax avoidance. From a traditional point of view, in other words, in the
absent of agency costs, corporate tax avoidance activities impose both costs and
benefits. With a nature of minimizing the tax liability of a company, tax avoidance
activities arguably transfer the state wealth to shareholders’ value. In terms of costs of
tax avoidance activities, there are direct costs regarding resources used to engage in
such activities, and potential costs of market scrutiny and reputation damages (Desai
and Dharmapala 2009). The trade-off between potential costs and benefits of tax
avoidance results in an uncertain effect of corporate tax avoidance on firm value.
Furthermore, agency theory considers managerial tax avoidance actions as possible
opportunities for managers to pursue self-interests (Desai and Dharmapala 2006).
Would the effect of agency costs be significant enough to reveal a loss of firm value?
Under the agency framework, corporate governance is relevant to mitigate such effect
of managerial diversion. Desai and Dharmapala (2009) further propose that the benefits
of tax avoidance activities in saving tax charges are possibly offset by the potential
managerial rent extraction for firms with weak corporate governance. Therefore, such
benefits and the net effect of tax avoidance are likely to be greater for firms with
stronger corporate governance.
Tax management generally refers to the activities that reduce firm’s tax liability. This
broad definition presents a continuum of which one end is perfectly legal activities as
strategic tax planning and the other extreme is illegal tax evasion (Dyreng et al. 2008;
Hanlon and Heitzman2010). To avoid distinguishing the legality of tax-reduction
activities, tax avoidance activities are those strategies between the two extremes of tax
management (Hanlon and Heitzman 2010). Definition of tax avoidance from tax
authority is relatively narrower, for instance, HMRC (2015) refers to tax avoidance as
gaining tax advantages in an unintended way of the law. The interest of tax authority is
more likely about estimating and tackling the tax gap rather than maximizing
shareholder wealth or reconciling principle-agent problems. The question, which part
of the continuum does tax avoidance activities fall in, depends on the aggressiveness of
tax management activities. The interest of prior research is intentional tax reduction
strategies at the aggressive extreme of the continuum. This research also focuses on the
aggressive end of tax management and defines tax avoidance following Hanlon and
Heitzman (2010) and Slemrod (2004) as a subset of tax management activities which
is to pay lower taxes by engaging in a wide range of transactions without an actual
response by the company.
The practices of corporate tax-related behaviours closely link to changes in tax regime
and the attitude of managers, shareholders and the general public with regards to tax
responsibility. According to the survey of KPMG (2016), 75% of companies respond
that a country’s tax system is the main reason that drives the choice of where to locate
the corporation. Compared to international peers, the UK has recently been considered
as a considerably attractive destination of business activities due to its competitiveness
of tax system (KPMG 2016). The competitiveness arises from the stability of the regime,
forewarning of big changes and simplicity resulting from previous tax reform. The UK
corporate tax rate has been reduced steadily since 1982 with a peak of 52% to 2016
with 20% as the lowest rate among G82 (Brooks et al. 2016). The environment in the
UK has recently shown a changing attitude towards corporate tax avoidance activities.
Some practices of tax avoidance become unacceptable by the general public(Brooks et
al. 2016). After a few years of calling for increased tax transparency and responsibility,
companies are responding along with improved transparent reports of tax affairs
(KPMG 2016). In terms of corporate tax-related activities, the study of UK firms
reflects the respond to a stable and well-developed tax regime.
The Recent publication of corporate “tax gap” 3 from HM revenue and Customs
(HMRC) is estimated to be £3.0 billion for 2013-2014, which compromises seven
percent of the estimated corporate tax liability. According to the report, the tax gap of
Large Business Service Corporation (LBS), which is £1.0 billion for 2013-14, £1.1
billion for 2012-13 and 2011-12, and £1.8 billion for 2010-11, could be attributed to
“avoidance risks” with 80%, 82% and 83% respectively. Although the tax gap of
corporate income tax has shown a reduction over the period of 2005-06 to 2013-14, the
interest and behaviour of reducing tax payment remain active.
Prior literature has long-standing interests on the tax effect of real corporate financial
decisions, such as tax effect on capital structure, dividend policy, compensation policy,
risk management, and organizational forms (Graham 2003). Instead of taking taxes as
one of the determinants of those decisions, could tax itself possibly be a decision of a
company? The answer to the question attracts attentions to corporate tax avoidance
activities. How tax avoidance decisions, which relates to reducing corporate tax liability,
affect firm value and cost of debts 4 , and could corporate governance mitigate or
encourage tax avoidance?
US research presents empirical results more in line with the notion of Desai and
Dharmapala (2006) agency framework. Cloyd et al. (2003), Hanlon and Slemrod (2009)
and Kim et al. (2011) find strong evidence suggesting that the market reaction to tax
avoidance activities is negative. Kim et al. (2011) also document that well-
governance firms tend to have greater net effect of tax avoidance resulting in an
increased firm value, consistent with the findings of Huseynov and Klamm (2012) using
Cash ETR. However, the results of empirical research seem to be sensitive to tax
avoidance measures and corporate governance quality. Desai and Dharmapala (2009)
fail to find a significant relationship between book-tax difference (BTD) and firm value
at an aggregate level which implies that the average effect of tax avoidance on firm
value could also be offset.
Recent UK study by Brooks et al. (2016) shows evidence that no negative or significant
relationship has been found between corporate tax payment and financial performance.
The study of Brooks et al. (2016) investigates the price reaction to tax rate changes by
2 Noted that Russia, which is currently suspended as a G8 member, also has a 20% corporate tax rate. 3 The “tax gap” is defined in the HMRC (2015) report as the difference between theoretical tax liability and the amount of tax which is actually collected. 4 Despite firm value, another influences of tax avoidance is on the cost of debts. Beck et al. (2014) argue that corporate tax avoidance, particularly illegal tax evasion activities, have been accused of being an important cause of sovereign debt crisis since they cause fiscal instability. The examination of tax avoidance could contribute to resolving the asymmetric information problem between shareholders and managers in the process of financial crisis (Beck et al. 2014).
using long-term ETRs during 1988 to 2014. In contrast, Abdul Wahab and Holland
(2012) find UK evidence consistent with the notion of agency framework on tax
avoidance that tax planning is negatively associated with the market value of equity,
but no evidence is found that corporate governance plays a role in mitigating the
relationship. They show that permanent book and tax difference is the component that
shapes the negative relationship.
Other studies further investigate which of the corporate governance techniques
influence corporate tax avoidance behaviour. Dyreng et al. (2010) show that individual
executives have a significant impact on the aggressiveness of tax avoidance level. Lanis
and Richardson (2011) find that the proportion of independent directors on the board
lowers the possibility of engaging in aggressive tax avoidance activities. Kubick and
Lockhart (2016) show strong evidence that incentives of the external labour market,
which motivates directors to be competitive for their employment position, is important
in determining the corporate aggressive tax strategies. By using various proxies to
examine the role of corporate governance mechanisms in tax avoidance activities,
Minnick and Noga (2010) find that compared to incentive compensation, especially
pay-performance-sensitivity, other corporate governance measures have less impact on
tax avoidance. They also document that tax avoidance with better corporate governance
results in higher returns for shareholders. Instead of using various proxies to measure
the corporate tax avoidance levels, Armstrong et al. (2015) use quantile regressions
associated with the extreme levels of tax avoidance distribution to examine the potential
shifts in the relation of tax avoidance in condition to different corporate governance
techniques. They find that board independence and financial sophistication could
mitigate the agency problem but high equity incentives increase the risk of moral hazard
by managers, consistent with the findings of Rego and Wilson (2012).
This paper contributes in the following. First, it provides UK evidence with regard to
shareholders’ valuation on tax avoidance of companies under UK tax regime. Second,
this research advances the knowledge of the effect of corporate governance on the
relationship between tax avoidance behaviours and firm value under agency framework.
Third, this paper employs various proxies of tax avoidance and corporate governance
and jointly examines the validity and reliability of those measures. Fourth, the
discussion of the interplay between corporate governance and tax avoidance may shed
light on the fundamental question whether better corporate governance techniques
result in increasing firm value (Minnick and Noga 2010). Fifth, the analysis is based on
a period of eight years and reflects the changing attitudes of tax avoidance over time.
In summary, the regression results show evidence that there is no significant
relationship between tax avoidance and firm value. The relationship between corporate
tax avoidance and firm value is found to be conditional to the level of corporate
governance at disaggregate level. The effect of tax avoidance is positive on firm value
for firms with strong corporate governance and insignificant for firms with weak
corporate governance. The results are consistent with the hypothesis that corporate
governance moderates the principle-agent problem. Among those corporate governance
techniques that have been examined, compensation incentives and board structure
appear to have impacts on corporate tax avoidance and other proxies of corporate
governance show no statistical significance on tax avoidance measures.
The remainder of the paper is structured as follows. Section 2 explores the underlying
theories and empirical evidence as well as develops the hypotheses for the relation
between tax avoidance, corporate governance and firm value. Section 3 discusses the
models used to test the hypotheses and the choices and measurement of key variables.
Section 4 describes the process of data collection and summary statistics of the sample.
Section 5 analyses the empirical results. Section 6 concludes and acknowledges the
limitations of the research.
2. Literature review and hypotheses development
There is a young and growing literature studying the effect of corporate governance on
tax avoidance and firm value. Hanlon and Heitzman (2010) argue that it would be hard
to determine the legality in advance of the fact of tax avoidance activities. The legal
ambiguity of tax avoidance strategies provides a ground for agency framework to
perceive tax avoidance as a risky investment which contains both positive potentials
and negative damages on firms. The following section gives a general review of the
recent stream of the related literature and discusses how corporate governance
mechanism influences the relationship between tax avoidance and firm value. Section
2.1 explains the fundamental framework of corporate governance, tax avoidance, and
firm value. Section 2.2 reviews the previous literature on tax avoidance and firm value.
Section 2.3 discusses empirical evidence regarding different corporate governance
characteristics relating to tax avoidance activities. Section 2.4 develops the control
variables included in regression analysis. Section 2.5 emphasizes on the measurement
problem engendered in empirical studies. Section 2.6 develops the hypotheses followed
by section 2.7 the conclusion.
2.1 Agency theory: a theoretical framework
Slemrod (2004) and Crocker and Slemrod (2005) construct a foundation of the
principle-agent framework in explaining the variation in corporate tax avoidance. The
separation of ownership and control indicates that shareholders cannot directly make
the tax decision and managers may have private information about the possible
reduction strategies in income taxes. Two thoughts under agency theory link corporate
governance to tax avoidance. One traditional notion is that higher level of incentive
compensation could encourage managers to behave more aggressively in tax avoidance
planning in order to increase the wealth of shareholders (Armstrong et al. 2015). In
contrast, another situation when engaging in tax avoidance activities allows managers
for rent extraction could alter this positive relationship (Desai and Dharmapala 2006;
Desai et al. 2007). Corporate governance in turns plays an important role in resolving
the principal and agent conflicts and thus reduces agency costs (McKnight and Weir
2009). Existing literature does not make a consensus on whether there is an optimal
value-maximizing corporate governance structure (Coles et al. 2008; McKnight and
Weir 2009). The research question regarding the effect of corporate governance on tax
avoidance activities provides insight on understanding the cross-sectional variation of
tax avoidance activities and the relationship between corporate governance, firm value
and tax avoidance.
2.1.1 Traditional view
Traditional view considers tax avoidance as value-added activities which managers are
motivated to take for maximizing the value of organization (Desai et al. 2007). Since
tax avoidance decision made by managers affects firm value in a positive way, early
studies focus on the efficiency of the decision which is to assess the benefits and the
cost of being scrutinized (Phillips 2003). The implication, therefore, is that the
contractual relationship may or may not lead to more aggressive tax planning due to
market scrutiny. However, Hanlon and Heitzman (2010) pinpoint that earlier research
on companies engaging in tax avoidance activities makes no assumption of agency costs
when considering managers making corporate decisions on the aggressiveness of tax
management. Under the traditional thought, shareholders could simply address the
agency problem by motivating managers to increase after-tax performance (Kim et al.
2011), e.g. to align compensation with after-tax measurement (Phillips 2003).
The Traditional view suffered from the ignorance of agency costs. Tax avoidance
activities may allow for managerial rent extraction which could offset the reductions
effect of tax expense on maximizing shareholders’ wealth and alter the proposed
positive relationship (Desai and Dharmapala 2006; Desai et al. 2007). Therefore,
shareholders may no longer value corporate tax avoidance activities (Desai and
Dharmapala 2009). Desai and Dharmapala (2006) propose that managers may extract
rents via tax-related activities. For instance, costs of engaging in tax sheltering activities
could more or less attribute to the degree of tax avoidance which depends on the own
perspective of the manager. Tax sheltering and managerial diversion are decisions made
at the same time, and more aggressiveness in tax avoidance could imply more
managerial extraction (Desai and Dharmapala 2006).
2.1.2 Tax avoidance and managerial rent extraction
The model of Desai and Dharmapala (2006) takes account of the problem of managerial
diversion or opportunism by incorporating agency costs into the model of tax avoidance
and firm value. Corporate governance under the agency model mitigates the negative
relationship between tax avoidance and firm value. Good quality of corporate
governance aligns the interests of managers and shareholders by enforcing better
governance techniques in preventing managerial diversion. Desai et al. (2007) argue
that good practices of corporate governance limit the extent to private benefits extracted
by managers and the extent to the impact of agency costs on firm value. Desai and
Dharmapala (2006) maintain that the effect of tax avoidance is conditional to corporate
governance. They predict that firms with well corporate governance are more effective
in preventing managerial diversion and thus the corporate governance incentives could
lead to higher levels of tax avoidance but positive influences on firm value. However,
firms with poor corporate governance are more interested in reducing tax sheltering for
lowering the opportunity of rent extraction (Desai et al. 2007).
Following the framework of Desai and Dharmapala (2006), empirical research shows
evidence of the interdependence of managerial opportunism and tax avoidance. Desai
and Dharmapala (2006) find that stronger equity incentives result in lower level of tax
avoidance for weak governance companies. Chen et al. (2010) show that non-family
firms are more tax avoidance than family firms. They argue that since other
shareholders may commonly presume that family has more opportunities to mask
benefits by various activities including tax avoidance, family owners respond to forgo
the benefit to avoid discounting share value by other shareholders who concern family
may extract rents.
2.1.3 Limitation on the agency model of tax avoidance
Some research questions the underlying assumption of the agency model that tax
avoidance facilitate managers to seek their own interests. The decision of managers for
firms engaging in tax avoidance depends on factors such as the relevance of information
(Gallemore and Labro 2015), organizational forms (Robinson et al. 2010), business
strategy (Higgins et al. 2015). Evidence from other studies also challenges that
corporate governance is not necessarily the predominant reason for explaining the
negative relationship between tax avoidance and firm value. For example, managers
may be concerned about market scrutiny, or shareholders themselves may not consider
tax avoidance activities as a value maximizing activities regarding the risk of rigorous
scrutiny and severe penalty (Graham and Tucker 2006; Brooks et al. 2016; Bebchuk
and Fried 2003; Hanlon et al. 2015).
Agency theory is useful for understanding tax avoidance activities related to the
compensation, especially in the case of tax avoidance activities enabling the managerial
diversion. However, when this assumption (that tax avoidance provides a channel for
managers to seek their own interest) is not sufficiently important, agency framework
could not provide a whole explanation of the direct effect between corporate
governance and tax avoidance (Lanis and Richardson 2011). Also, when managers have
a limited discretion grant to make tax decision, corporate governance mechanism could
no longer explain the effect of tax avoidance on firm value. The decision of managers
could be significantly influenced by other variables, such as concerns of reputation cost
(Graham Tucker 2006), information quality and availability (Gallemore and Labro
2015), controllability (Robinson et al. 2010), tax knowledge (Cook et al. 2008; McGuire
et al. 2012), corporate social responsibility (Huseynov and Klamm 2012a).
2.2 Tax avoidance and firm value
Empirical evidence shows mixed results on the relationship between tax avoidance and
firm value. The inference contains a debate on whether the share price is negatively,
positively or not associated with bad news with regard to corporate tax liability. In the
world without agency costs, shareholders with different levels of risk aversion could
value tax avoidance on opposite directions and the overall effect of tax avoidance news
might therefore be offset. From the traditional point, aggressive tax planning activities
save costs and increase firm value (Kim et al. 2011). However, the traditional view is
unlikely to fully explain mixed responses. As previously discussed tax avoidance may
facilitate managerial diversion and imposes agency costs (Desai and Dharmapala 2006).
Cloyd et al. (2003) investigate the reactions of stock price to the news announcement
that firms will expatriate to tax haven countries and conclude that the market does not
believe that the benefits of fewer tax expenses outweigh or offset the costs. In terms of
news about the involvement in tax sheltering activities, Hanlon and Slemrod (2009)
adopt a method of event study and examine the response of share prices by employing
data of 108 US firms during the year 1990 to 2004. They find that share prices drop
0.5% as a reaction to tax shelters participation disclosure but the price decreases are
muted for well-governance firms. Kim et al. (2011) extend the explanatory power of
the agency model by employing a sample of US listed companies. They documented a
long run effect of more aggressive tax avoidance on firm value. All measures they used
for tax avoidance, cash ETR, large book-tax differences (BTD) and tax sheltering
incentive are found having a significant relationship with stock price drops. They also
find evidence that higher tax avoidance could predict crashes in future stock price and
external governance mechanisms diminish the risk of dropping in firm value.
In contrast, Desai and Dharmapala (2009) show evidence that there is no significant
relationship between book-tax difference (BTD)5, a proxy for measuring aggressive tax
avoidance activities (discussed more in detail in section 3.3.2) and firm value, measured
by Tobin’s q in their study. A significant effect is found in a disaggregate level consistent
with the agency framework. They show that firms with strong corporate governance
appear to have a significantly positive association between tax avoidance and firm value,
and firms with weak corporate governance shown a negative relationship. Recent UK
study by Brooks et al. (2016) uses data of FTSE All share companies and they show no
relationship between corporate tax payment and financial performance. Brooks et al.
(2016) find that despite short term falls for some small firms, there is no long-term drop
in share price relating to current ETRs, long term ETRs, BTDs, which contradicts to
the findings of Cloyd et al. (2003). They argue that tax aggressiveness of managers or
any decision on changes in tax rates represents an evaluated and rational decision
process accounting for the costs and benefits of corporate tax avoidance. They conclude
that by considering ‘responsible’ investors who keep an eye on corporate tax avoidance,
the aggressiveness of senior managers in tax avoidance will not likely to affect stock
prices. However, unlike the study of Cloyd et al. (2003) which tests the direct
relationship between stock price and corporate expatriation news in a two-year window,
the study of Brooks et al. (2016) investigates the price reaction to tax rate changes by
using long-term ETRs. The information included in ETRs and BTDs is subject to
measurement error which could be caused by the limitation of accounting-based
measures.
2.3 Corporate governance and tax avoidance
As previously discussed, tax avoidance activities may be conditional to the
effectiveness of corporate governance. Prior literature suggests that not only the overall
quality of corporate governance structure but also the individual corporate governance
mechanism relates to tax avoidance activities and have an effect on firm value. Minnick
and Noga (2010) make a comprehensive investigation of the role of corporate
governance plays in tax aggressive management and estimate whether tax planning with
better corporate governance increases the shareholder wealth in the long run. They find
the important effect of corporate governance, of which the most important driver of tax
avoidance decisions is incentive compensation, especially pay-for-performance
sensitivity. However, their study has yet to explore the world outside the US. In order
to investigate the UK practices in this research, the following sections adopt the
classification by McKnight and Weir (2009) of corporate governance characteristics:
board structure, ownership structure, incentives compensation.
5 Noted that book-tax difference could also be caused by earning management, Desai and Dharmapala (2009) used total accruals as control variable to separate the effect of tax avoidance activities.
2.3.1 Board structure and tax avoidance
A substantial literature has investigated the link between performance and board
structure, referring to the board size and the components. However, mixed results are
shown towards the optimal board structure of a corporation. Early literature suggests
that smaller and more independence board tends to have higher firm value(Jensen 1993;
Eisenberg et al. 1998; Yermack 1996). However, recent studies argue that there is no
optimal board structure. Boone et al. (2007) and Coles et al. (2008) show evidence that
board sizes and outside directors vary by firm-level characteristics. In addition, some
argue that larger board size tends to compromise more to make a consensus. Cheng
(2008) shows empirical evidence that large board is significantly related to less
volatility in firm value.
Prior studies suggest that more outside directors on board reduce the agency costs and
the new of appointment to outside directors leads to an increase in equity value
(Rosenstein and Wyatt 1990). In particular of all the research on board structure, the
study of Richardson et al. (2014) links the board effect with corporate tax avoidance
and the decision to capital structure in terms of debt policy 6 . Their study show
intervention from the broad on tax avoidance activities and find evidence that firms
with a higher fraction of outside directors increase their debt-substitution effect where
the debt-substitution effect is defined as debt being a substitute to tax aggressive
activities. The implication would be consistent with other empirical results that
companies with a higher level of board independence result in less influence of
managers (Coles et al. 2008).
Other board characteristics have also been examined in prior research but have shown
weak impact on lowering the agency costs. In contrast to the argument that gender
diversity could result in higher risk of the firm, Sila et al. (2016) find no evidence that
more women on the board affect the firm performance. McKnight and Weir (2009)
found little evidence in supportive of an important effect of the duality of CEO/Chair
on firm value. However, Bhagat and Bolton (2008) document a significantly positive
relationship between the separation of CEO/Chair and corporate operational
performance. They also conclude that an overall quality of corporate governance could
be measured by board independence or ownership structure.
2.3.2 Ownership structure and tax avoidance
Ownership structure with a composition of institutional ownership, managerial
ownership, and family ownership contributes to another part of corporate governance
mechanisms. Institutional investors are argued to be powerful shareholders with more
active engagement of voting. They are considered as having superior knowledge and
resources to monitor managers (McKnight and Weir 2009; Desai and Dharmapala
2009). Thus, a higher level of institutional ownership could better monitor managers in
order to reduce agency costs. Lim (2011) extends Desai and Dharmapala (2006) model
by examining and documenting a negative relationship between tax avoidance and cost
of debt. It is found that the negative relationship is magnified when institutional
ownership is higher. Their study adopts institutional ownership as the proxy of
6 Graham and Tucker (2006) document a debt-substitution effect. They find evidence that firms engaging in tax sheltering activities appear to have an 8% less debt ratios compared to matched pre-sheltering firms.
corporate governance7 and suggests the important effect of institutional ownership on
monitoring managerial extraction. A similar study by Kim et al. (2011) also shows that
institutional ownership as one of the external governance sources has an important
effect on mitigating the negative impact of tax avoidance on firm value. Desai and
Dharmapala (2009) also adopt institutional ownership as the proxy for governance
quality and find evidence consistent with the proposal that benefits from corporate tax
avoidance depend on the quality of corporate governance. Overall, prior evidence
suggests that higher institutional ownership leads to lower chance of rent extraction.
Under the agency model, increased managerial ownership provides more incentives for
managers to act on behalf of the interest of the shareholders. Kim and Lu (2011)
document that under weak external governance (EG) measured by industry
concentration ratio and institutional ownership concentration, CEO ownership has more
room to mitigate agency problems via motivation effect. When EG is strong, the
relationship between CEO ownership and Tobin’s q is shown being insignificant. They
also find evidence that the level of R&D investment, which is used for measuring the
risk-taking decisions of CEOs, is affected by the quality of external governance. Their
findings also provide insights on the notion of tax avoidance research under agency
model. In terms of family ownership, family firms appear to manage tax payments less
aggressively than that of non-family firms (Chen et al. 2010). However, in this case,
family owners avoid tax avoidance strategy for the reason of reputation costs and
possible penalties but not interest alignment.
2.3.3 Incentives compensation and tax avoidance
Most literature on executive incentives and CEO tax aggressive preferences focuses
mainly on compensation incentives. Empirical evidence shows that managers’ decision
on corporate tax avoidance strategies is most sensitive to managerial compensation
compared to board structure and age of the CEO (Minnick and Noga 2010). Specifically,
managerial compensations such as equity-based incentives (Rego and Wilson 2012) and
Pay-for-performance sensitivity (Minnick and Noga 2010) have been found driving
executives to behave in the way that increases shareholders’ wealth. Tournament
incentive which refers to the difference between total compensation of the CEO and
those of the near-highest paid CEO in the industry, has been found playing an important
role in affecting tax decisions. A Recent study of Kubick and Lockhart (2016) show
evidence that the external labour market has been an effective motivation for CEOs to
undertake aggressive tax strategies.
2.3.4 Other corporate governance characteristics and tax avoidance
Other corporate governance characteristics may also influence corporate tax avoidance.
In terms of characteristics of the CEO, Francis et al. (2016) show that whether the CEOs
are Democratic or Republican affect their decisions to engage in tax sheltering activities.
Other factors such as overconfidence (Huang et al. 2016) and national culture
(DeBacker et al. 2012) has shown to affect the risk adverse preference of the managers.
From the view of stakeholders, Chyz et al. (2013) examine the influence of labour
unions on corporate aggressive tax management and they document a negative
7 Noted that Desai and Dharmapala (2009) also measure institutional ownership which as the proxy of good corporate governance has been widely used in empirical literature under Desai and Dharmapala (2006) model and find consistence results.
association between tax avoidance and union power, measured by unionization rate and
bargaining power. Their findings further suggest that stakeholders are likely to have an
important effect on corporate tax aggressive strategies.
Overall, prior literature provides extensive evidence on the effect of corporate
governance and develops various measures of governance techniques. Nevertheless, it
is important to note that corporate governance varies significantly by countries. An
empirical study on UK practices by McKnight and Weir (2009) shows no significant
effect of board structure on the agency costs. Abdul Wahab and Holland (2012) also
find UK evidence contradicts to US results that corporate governance shown no
mitigating effect on agency conflicts and tax avoidance activities. They conduct a factor
analysis to determine the governance mechanism which could reflect the quality of
corporate governance. The following sections of this paper also investigate the
effectiveness of different corporate governance techniques with the purpose of testing
the relations to tax avoidance activities.
2.4 Control variables: firm characteristics
The prior literature identifies several firm characteristics for controlling the cross-
sectional variation on corporate tax avoidance activities. Earlier research has extensive
focuses on the rationale of firm size and different effective tax rates. Mixed results have
been found due to different measures of firm sizes8, sample period and the specific
model (Rego and Wilson 2012). Zimmerman (1983) show evidence that firm size is
positively related to effective tax rates (ETR)9. In terms of UK setting, Holland (1998)
documents a size effect is related to average ETR during 1968-1979 and finds a negative
relation from the late 1970s to early 1980s. In contrast, Stickney and McGee (1982) and
Gupta and Newberry (1997) find size factor has no significant relationship with ETRs
but other firm characteristics such as capital intensity, leverage, capital structure and
asset mix are shown significantly associated with ETRs.
Shiing-Wu (1991) present the result that net operating loss (NOL) has statistically
importance on the variation of ETRs. Empirical studies also document that the effect of
determinants is not widely spread across industries. Samples from oil and gas
companies were found to have highest ETRs but wholesale and retail industries resulted
in lowest ETRs (Zimmerman 1983). Klassen and Laplante (2012) identify another firm
characteristic that the high level of foreign reinvestment signals companies with
subsidiaries located in lower foreign tax rates places having more incentives as well as
opportunities to shift income. Companies with high R&D percentage are shown have
more chance to shift profits overseas (Klassen and Laplante 2012). In term of leverage,
Graham and Tucker (2006) show that compared to a control sample, tax shelter
companies have lower leverage ratios. Brooks et al. (2016) argue that capital intensive
companies could have more opportunities to avoid taxes through depreciation of assets.
8 Moore (2012) summarise that firm size can be calculated by numerous measure, e.g. net income, gross receipts, business value and number of employees. The result of this study also shows patterns in long term ETR changes. 9 The notion of earlier studies investigating variation of ETR is that under the “political risk hypothesis”, large firms are subject to greater possibility of market scrutiny and ETRs are expected to partly measure the political risks(Zimmerman 1983).
2.5 Endogeneity problem and sample bias
Endogeneity problem of corporate governance research could cause serious
measurement problems. Endogeneity occurs in a multiple regression when the
independent variable is associated with the error term. Endogeneity problem causes the
OLS estimators to be biased and inconsistent which will result in either overestimate or
underestimate the parameters. There are few cases which lead to endogeneity. First, the
regression model may exclude an important variable and the omitted variables could
affect both the independent and dependent variables. For example, there might be an
uncontrolled or unrecognized variable that affects both the CEO characteristic and
corporate tax sheltering activities (Francis et al. 2016). Second, the measurement error
of independent variable could also cause endogeneity problem. Separating tax
avoidance effect from earnings management or aggressive reporting with regard to
accounting measures of tax avoidance could be complicated. Desai and Dharmapala
(2009) state that the implication of the regression results is limited because of the
possibility of having measurement errors of tax avoidance proxies. Third, endogeneity
arises from simultaneity10 when independent variables are jointly determined with the
dependent variable. For instance, tax sheltering activities could increase company’s
market capitalization as well as motivate executives to exercise their share option(Desai
and Dharmapala 2006). Neglecting the above kinds of measurement problem could lead
to bias results or spurious relationship (Wintoki et al. 2012).
Prior empirical research makes a lot of effort in controlling for endogeneity problem by
conducting robustness test. Substantial studies include control variables and fixed effect
into the model to avoid the effect of omitted variables. Robustness test is also widely
tested in additional to the regression analysis. With regard to measurement error in
independent variables, the approach of instrumental variables (IV), which is to include
an instrument unrelated to the error term into the regression model, can solve the
inconsistency problem caused by endogeneity. However, the estimates are still bias
under IV method and the efficiency of the method is limited to the quality of the
instrument. The robustness could also be tested by including lagged variables of the
independent variables (Wintoki et al. 2012). For example, Desai and Dharmapala (2009)
check the robustness by incorporating lagged variables of the tax avoidance proxy.
Minnick and Noga (2010) include lagged differences of ETR into the model. Moreover,
a majority of studies also conduct robustness tests by using alternative measures of the
independent variables, i.e. other proxies of tax avoidance and corporate governance
techniques (Lim 2011; Abdul Wahab and Holland 2012; Desai et al. 2007).
A great number of empirical studies of corporate governance and firm value focus on
different samples from a single country to the worldwide practices. However, there is a
lack of research in investigating the links between corporate governance, tax avoidance,
and firm value apart from the view from US sample. A few studies have extended the
perspective towards evidence from Russia (Desai et al. 2007; Mironov 2013; DeBacker
et al. 2012), Korea (Lim 2011), China (Zhang et al. 2016) and the UK (Brooks et al.
2016; Abdul Wahab and Holland 2012). Little is known about the practices outside the
US. Furthermore, prior studies tend to exclude the financial industry from their sample
and the results would fail to account for the unknown characteristics of financial
institutions regarding corporate governance and tax avoidance.
10 Simultaneity is defined when X is not random but a function of Y (Wintoki et al. 2012).
For studies adopting the measurement of tax sheltering, the sample of tax sheltering
firms would be limited to those which have been publicly accused of engaging in tax
sheltering activities. The result from tax sheltering companies can be biased since it
ignores other silent firms. For instance, research using tax sheltering proxies may ignore
companies which have hidden tax avoidance activities since the sample only includes
firms being exposed of engaging in tax sheltering activities. The result of tax sheltering
model would fail to capture the firm characteristics of those silent companies(Graham
and Tucker 2006; Desai and Dharmapala 2006). Moreover, the current tax shelter
sample is based on studies of US firms, and thus the tax sheltering regression results
may be biased to non-US companies. Also, including firms which are accused of
involving in tax sheltering activities may cause endogeneity problem since the included
firms are likely to be those with the least care of social response such as reputation cost
(Graham et al. 2014).
2.6 Hypotheses development
To examine the relationship between corporate governance, tax avoidance, and firm
value, the first step would be to test the hypotheses under agency framework. The
agency framework proposes that tax avoidance activities provide greater opportunities
for managers to extract rents from the companies. Therefore, tax avoidance would
imply a decrease in firm value. A negative relationship between tax avoidance and firm
value indicate that the effect of managerial diversion outweighs the potential benefit of
tax avoidance strategies. Prior research found result consistent with the notion of
agency framework. Mironov (2013) shows that diversion activities negatively affect the
firm value. Kim et al. (2011) find a significantly positive relationship between tax
avoidance and firm idiosyncrasy risk in stock price. Thus, it could be expected that
companies with a higher level of tax avoidance have lower firm values. Accordingly,
this research test the following hypothesis (H1).
H1: Tax avoidance is negatively related to firm value.
According to Desai and Dharmapala (2006) model, the quality of corporate governance
influences the ability of managers to extract rents since well-governance companies are
more likely to have stronger control techniques that prevent managerial diversion.
According to the level of corporate governance, firms could be categorized into two
extremes. Strong corporate governance is expected to mitigate the problem of
managerial diversion, and weak governance may worsen the problem. H1 considers the
average effect of shareholder’s valuation on tax avoidance. H2 is expected to investigate
whether the quality of corporate governance makes a difference to the relationship
between firm value and tax avoidance activities.
H2: All else being equal, the negative relationship of tax avoidance and firm value is
mitigated by strong corporate governance.
There is extensive evidence that corporate governance techniques improves firm value.
In another aspect of agency framework, tax avoidance can be seen as a risky investment
available to managers similar to other investments which are influenced by corporate
governance. Without the assumption of managerial diversion, several studies examine
how corporate governance would improve firm value by testing the direct relationship
between corporate governance and tax avoidance. Armstrong et al. (2015) argue that
given the unsolved Principle-agent problem, managers may choose a level of tax
avoidance which shareholders may disagree. The third hypothesis (H3) examines the
direct relationship between corporate governance and tax avoidance by incorporating
various corporate governance mechanisms into the model.
H3: Increased quality of corporate governance techniques leads to higher tax avoidance,
in other words, lower tax expenses.
The test of H3 does not necessarily assume that tax avoidance activities create
opportunities for rent extraction. But it assumes that various corporate governance
techniques mitigate the agency problem by controlling tax avoidance activities
(Armstrong et al. 2015). Within the agency model, strong governance better aligns the
interest of managers with corporate value-maximization. H3 further investigates the
specific corporate governance techniques (board size, board independence, the duality
of the CEO, ownership structure, and stock compensation) that tax avoidance activities
are sensitive to. Larger boards may have more difficulties in convincing managers to
allocate resources to tax avoidance activities. Independence board can be more flexible
in diverting resources to tax avoidance which implies that more independence board
has greater incentives to pursue a higher level of tax avoidance. In terms of
compensation, since the purpose of managerial incentives is to motivate managers
acting on behalf of shareholders, higher stock compensation is expected to result in
lower tax expenses, in other words, higher tax avoidance is likely to be associated with
higher stock incentives. Alternatively, H3 can be stated as above. Noted that the tests
of H1, H2 and H3 are all single-sided test.
2.7 Summary of literature review
The agency framework lays a foundation for empirical research to investigate the
relationship between corporate governance tax avoidance and firm value. The model of
Desai and Dharmapala (2006) extends the theoretical ground by assuming managerial
opportunism with regards to tax avoidance activities. Tax-related literature also
contributes to the knowledge of how corporate governance affect firm value. Research
under agency framework advances the knowledge of the effect of corporate governance
on the relationship between tax avoidance behaviours and firm value. Second, research
on this areas jointly examines the role of corporate governance as well as tax avoidance
activities on firm value. Third, the research also sheds light on the other consequences
of the interaction between corporate governance and tax avoidance, such as debt policy,
the cost of debt, bondholders. Further research of these areas will possibly push the
boundaries of existing body of knowledge to corporate governance regarding many
other disciplines.
3. Methodology
3.1 Research design
𝐹𝑉𝑖𝑡 = 𝛽0 + 𝛽1𝑇𝐴𝑖𝑡 + ∑ 𝛽𝑛𝐶𝑜𝑛𝑟𝑜𝑙𝑖𝑡
6
𝑛=2
+ 𝜃𝑡 + 𝛿𝑖 + 𝜖𝑖𝑡 (1)
Following the regression model from previous studies by Mironov (2013), Desai and
Dharmapala (2009) and Kim and Lu (2011), equation (1) is the regression model for
testing H1. 𝐹𝑉𝑖𝑡 is the firm value which has been measured by Tobin’s q (most
common proxy) and market capitalization (Brooks et al. 2016; Desai and Dharmapala
2009). 𝛽0 is the constant. The coefficient of tax avoidance is 𝛽1 which implies the
sensitivity of the firm value to changes in tax avoidance levels across firms. According
to H1, 𝛽1 is expected to be negative for BTD based measures, and be positive for ETR
measure. 𝑇𝐴𝑖𝑡 is the measure of corporate tax avoidance which is measured by current
ETR, BTD and permanent BTD. 𝜃𝑡 controls for firm-fixed effect and 𝛿𝑖 controls for
year-fixed effect. ∑ 𝛽𝑛𝐶𝑜𝑛𝑟𝑜𝑙𝑖𝑡6𝑛=2 are control variables for various firm
characteristics including size measured by sales, foreign income, R&D expense,
leverage and capital intensity (Zimmerman 1983; Gupta and Newberry 1997; Shiing-
Wu 1991; Klassen and Laplante 2012).
𝐹𝑉𝑖𝑡 = 𝛽0 + 𝛽1𝑇𝐴𝑖𝑡 + 𝛽2𝐶𝐺𝑖𝑡 + 𝛽3𝑇𝐴𝑖𝑡 × 𝐶𝐺𝑖𝑡 + ∑ 𝛽𝑛𝐶𝑜𝑛𝑟𝑜𝑙𝑖𝑡
8
𝑛=4
+ 𝜃𝑡 + 𝛿𝑖
+ 𝜖𝑖𝑡 (2)
Equation (2) is the regression model for testing H2 where 𝐶𝐺𝑖𝑡 is the proxy for
corporate governance which is measured by corporate governance score. According to
the H2, 𝛽3 is expected to be positive when using BTD-based measures and to be
negative when using ETR-based measures, which implies that when corporate
governance has higher quality, the effect of tax avoidance on firm value is greater across
time and firms(Desai and Dharmapala 2009). Equation (3) is the regression model for
testing H3 following Minnick and Noga (2010) and Huseynov and Klamm (2012),
where 𝛽1−6 measure the effect of each corporate governance techniques on corporate
tax avoidance activities. ∑ 𝐶𝐺𝑖𝑡 represent three types of corporate governance
techniques, board structure, ownership structure and managerial incentives. According
to available corporate governance data in Datastream, ∑ 𝐶𝐺𝑖𝑡 includes corporate
governance mechanisms proxies as board size, board independence, CEO/Chairman
duality, ownership structure, CEO stock compensation and total senior executives
compensation.
𝑇𝐴𝑖𝑡 = 𝛽0 + ∑ 𝛽𝑛𝐶𝐺𝑖𝑡
6
𝑛=1
+ ∑ 𝛽𝑚𝐶𝑜𝑛𝑟𝑜𝑙𝑖𝑡
11
𝑚=7
+ 𝜃𝑡 + 𝛿𝑖 + 𝜖𝑖𝑡 (3)
It is noticed that substantial literature focuses on the most aggressive form of tax
avoidance. Several studies using GAAP ETR and Current ETR find no significant
relationship between firm value and tax avoidance (Brooks et al. 2016). Equation (2)
captures the average effect of corporate governance on the mitigation of agency
conflicts using Ordinary least square (OLS) method. Prior research has adopted two
methods in examining the effect of corporate governance without narrowing the view
on the central location of the sample distribution. Armstrong et al. (2015) use quantile
regressions to provide a view of the distribution and to allow for analysis of special
quantiles (Valta 2012). The other method is to classify the whole sample into
subsamples of good corporate governance and bad corporate governance firms, and
then re-run the regression for H1 and H2 on each sub-samples for comparing the
coefficients, 𝛽1and 𝛽3, of each subsample as well as the whole sample (Kim and Lu
2011; Desai and Dharmapala 2009). It is also noticeable that the regression model can
incorporate long term measures of tax avoidance, such as long-run ETRs (Dyreng et al.
2008), matching with other variables along the same period of time (Minnick and Noga
2010). The discussion of long term tax avoidance activities is not included in this paper,
however, it is a further aspect of investigation.
3.2 Measuring corporate governance
This paper employs as many of relevant corporate governance mechanisms as these are
available to Thomson Reuters ASSET4 ESG database. Thomson Reuters Datastream
ASSET4 ESG has provided timely and comprehensive data regarding environmental,
social and corporate governance (ESG) issues for more than 5000 global companies
including UK company level data since 2002. Data from ASSET4 ESG have been
widely used and tested in the recent UK and US studies (Boubakri et al. 2016; Lys et
al. 2015; Halbritter and Dorfleitner 2015; Stellner et al. 2015; Ferrell et al. 2016).
ASSET4 ESG is therefore considered as a reliable source of the database to obtain
corporate governance data.
Prior research has employed different proxies, such as institutional ownership, board
independence, and corporate governance score to measure the quality of corporate
governance. According to the UK study by Abdul Wahab and Holland (2012), board
independence referring to the proportion of outside directors on the board, and
institutional ownership defined as the proportion of shares held by institutions, are
found as the corporate governance mechanism that can capture the board corporate
governance level. Due to data availability, institutional ownership cannot be obtained
via Thomson ASSET4 ESG. This paper therefore primarily uses board independence
as the measure of corporate governance. Board independence (BI) (#CGBSO07S) is the
percentage of non-executive directors on the board. The underlying notion of this
measure is that independent directors have greater motivation and capacity to monitor
the performance of managers.
In terms of corporate governance score, Wilson (2009) documents that tax shelter
companies with better corporate governance, measured by corporate governance scores,
show higher abnormal returns. He uses corporate governance score of Gompers et al.
(2003) index ranging from 0 to 24 to measure the quality of corporate governance and
breaks the sample by the median score to distinguish good and bad corporate
governance. Hanlon and Slemrod (2009) also employ corporate governance score from
Gompers et al. (2003) to an event study of share price reaction to tax sheltering news.
Doidge and Dyck (2015) use another corporate governance score which has a range
from 0 to 100 to study the role of tax incentives on corporate decision making.
Corporate governance (CG) (#CGVSCORE) used in this paper is scores which measure
the system and process of a firm in ensuring board members and managers behave in
the best interest of shareholders. It has a range from 0 to 100 and is provided by
ASSET4 ESG. However, there is a lack of evidence relates to the reliability of the
corporate governance score provided by ASSET4 ESG, and thus this paper considers
corporate governance score as an additional measure to test Equation (2) apart from the
main results by board independence.
With regard to specific corporate governance mechanisms, this paper employs board
size, CEO/Chairman duality, ownership structure indicator, stock compensation for
executives and total senior executives compensation. Board size (BS) (#CGBS) is
measured by the total number of board members at the end of each financial year.
CEO/Chairman duality (CCD) (#CGBSO09S) is a dummy variable that equals 1 if the
chairman is also the CEO and equals to 0 when there is no duality. Ownership structure
(OSTR) (#CGSRO05S) is represented by scores which evaluate whether a powerful
shareholder has the majority of the votes. CEO stock compensation (CEOC)
(#CGCPDP041) is a dummy variable which equals to 1 when CEO’s compensation is
linked to total shareholder return and equals to 0 when it is not the case. Total senior
executives compensation (TOMP) (#CGCPDP054) is defined as the value of total
compensation paid to all senior executives.
3.3 Measuring tax avoidance: the extreme effect versus average effect
There has been a wide range of measures capturing different levels of corporate tax
avoidance. Since each measure of tax avoidance has its own inference and limitations,
extant research tends to include few proxies together into the analysis to obtain wider
inference. As tax avoidance generally refers to a continuum of tax reduction behaviours,
measures capturing the extent to tax avoidance have different inferences and limitations.
Hanlon and Heitzman (2010) state that the choice of tax avoidance proxy depends on
the specific research question. In order to choose tax avoidance measures for this
research, the following part summarizes and reviews measures which are frequently
used in prior literature (Table 1).
3.3.1 ETR-based measures
Effective tax rates (ETRs) have been most widely used for measuring tax avoidance in
prior research. By changing the definition of the numerator (Table 1), ETRs proxies
could reflect various tax avoidance behaviours. Earlier studies commonly measure the
average ETRs (also as GAAP ETRs or book ETRs) which incorporate both timing
effect of deferred strategies and aggressive tax planning activities (Hanlon and
Heitzman 2010; Abdul Wahab and Holland 2012). It has good properties in reflecting
the overall effect of tax avoidance activities which is directly related to accounting
income while it fails to distinguish the forms of avoidance (Dyreng et al. 2008). Current
ETR and cash ETR (defined in table1) appear to overcome the problem of detecting the
deferral tax charges. Prior studies document that cash ETRs show more volatility than
GAAP ETRs (Dyreng et al. 2010) and low ETRs show persistence over a long period
of time (Dyreng et al. 2008)11. GAAP ETR, current ETR, and Cash ETR are all short-
term proxies which could be affected by accounting accruals. Dyreng et al. (2008)
develop the concept and measure of long run ETR for capturing a longer horizon of tax
management and the long-term effect of determinants. Long run ETRs avoid the impact
of one single event (Minnick and Noga 2010; Dyreng et al. 2008) and also overcome
the problem of mismatching cash taxes with earnings(Hanlon and Heitzman 2010).
ETR volatility is the standard deviation of ETRs.
Discretionary permanent book-tax differences (DTAX) is the unexplained part between
ETR and statutory tax rate differential, see Frank et al. (2009). DTAX measures the
discretionary portion of tax avoidance activities and is associated with actual cases of
tax sheltering (Frank et al. 2009). However, Hanlon and Heitzman (2010) argue that
DTAX is likely to be problematic since the model requires non-tax driven determinants
but it is hard to decide one since the tax has potential effect on many corporate decisions.
The failure in using valid proxies would thus lead to additional error. Both measures
capture the variation of ETRs. ETR volatility and DTAX show the extent to tax
avoidance activity, although the variability could also be attributed to other changes.
11 It is possible that cash/current ETRs tend to overstate the tax burden due to compliance between accounting standards and tax law. For instance, more accelerated depreciation method distort the result of cash/current ETRs but not that of GAAP ETRs (Huseynov and Klamm 2012a; Hanlon and Heitzman 2010; Dyreng et al. 2010).
TP = Statutaryrate𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 ×(Perminant difference + timing difference) +STRDIFF = Pretax profit ×
(Statutaryrate𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 −𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
𝑃𝑟𝑒𝑡𝑎𝑥 𝑝𝑟𝑜𝑓𝑖𝑡)
12 Some studies use book income less special items as the denominator which would not cause big difference. 13 Dyreng et al. (2008) develops the long run ETR measure and the measurement period could normally take up to from 3 years to as long as 10 years. Similarly, Minnick and Noga (2010) measure long run
GAAP ETR which the numerator is calculated by sum of total tax expense over the given period. 14 See Gallemore and Labro (2015). 15 Frank et al. (2009) develop the measure of DTAX which incorporate the effect of tax avoidance on accounting earnings. 16 The method of tax sheltering model initially proposed by Wilson (2009)and then developed by Lisowsky (2010) to estimate the probability(𝑝𝑡𝑎𝑥 𝑠ℎ𝑒𝑙𝑡𝑒𝑟) of tax sheltering. 17 See Abdul Wahab and Holland (2012). They define STRDIF as the ETR reconciliation which is calculated by STRDIF = (Statutary rate𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 − Statutary Rate𝑜𝑣𝑒𝑟𝑠𝑒𝑒) × TP𝑜𝑣𝑒𝑟𝑠𝑒𝑎𝑠
Table 1 Measures of corporate tax avoidance
Measure Definition Calculation Duration
measured
Indicate
deferral
strategies?
Indicate
conforming
activities?
Related to
accounting
earnings?
Reflect
aggressiven
ess?
ETR-based measures GAAP ETR or
Book ETR12
Total tax payment per book income before tax One year No No Yes General
Current ETR Current tax expense per book income before tax One year Yes No Partly General
Cash ETR Overall cash taxes outflows per book income
before tax One year Yes No No General
Long-run cash
ETR13
Total cash paid for tax over total pre-tax
income Multiple years Yes No No General
ETR volatility14 The standard deviation of cash ETR over a
given period Multiple years Yes No Yes General
DTAX15 Discretionary permanent book-tax differences,
i.e. the unexplained part between ETR and
statutory tax rate differential
Residual from the regression ETR Differential× Pretax accounting income= α + βControls + ε
One year No No Yes Extreme
BTD-based measures
Total BTD Total book and taxable income differences One year Yes No Yes General
Temporary
BTD
Timing differences including loss relief One year Yes No Yes Moderate
Permanent BTD Permanent differences between accounting
income and taxable income. One year No No No Moderate or
extreme
Tax shelter
Tax shelter
indicator16
Dummy variable set equals to 1 if firm is
engaged in tax sheltering
𝑝𝑡𝑎𝑥 𝑠ℎ𝑒𝑙𝑡𝑒𝑟
1 − 𝑝𝑡𝑎𝑥 𝑠ℎ𝑒𝑙𝑡𝑒𝑟= α + βX + ε One particular
year
Might be Partly Depends Extreme
Tax planning
incentive17
The extent to tax planning considering after-tax
effect
One year Might be Partly Depends General
UTB Unrecognized tax benefits attribute to uncertain
tax position Disclosure of financial reporting One year If known, yes Partly Yes Extreme
𝑇𝑜𝑡𝑎𝑙 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
𝑃𝑟𝑒 − 𝑡𝑎𝑥 𝑎𝑐𝑐𝑜𝑢𝑡𝑛𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
𝑃𝑟𝑒 − 𝑡𝑎𝑥 𝑎𝑐𝑐𝑜𝑢𝑡𝑛𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
𝐶𝑎𝑠ℎ 𝑡𝑎𝑥𝑒𝑠 𝑝𝑎𝑖𝑑
𝑃𝑟𝑒 − 𝑡𝑎𝑥 𝑎𝑐𝑐𝑜𝑢𝑡𝑛𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒
√1
𝑡∑(𝑐𝑎𝑠ℎ 𝐸𝑇𝑅𝑡 − 𝐸𝑇𝑅𝑡
)
∑ 𝐶𝑎𝑠ℎ 𝑡𝑎𝑥𝑒𝑠 𝑝𝑎𝑖𝑑𝑡
∑ 𝑃𝑟𝑒 − 𝑡𝑎𝑥 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑖𝑛𝑐𝑜𝑚𝑒𝑡
Overall, since firms have incentives to reduce taxes, prior research suggests that lower
ratio of ETRs indicates a higher level of tax avoidance. Higher ETR volatility or higher
DTAX indicates increased tax avoidance (Frank et al. 2009; Rego and Wilson 2012).
Effective tax rates (ETRs)-based proxies reflect some degree of tax avoidance. However,
since ETRs are accounting-based measures, they would include the effect of other
causes such as aggressive financial reporting. The measures would be noisy as the
inference could not be specified. But ETR-based measures have a merit that they enable
for running large sample since ETR data are highly visible.
3.3.2 BTD measure and contrast
Book-tax differences (BTDs) measure the overall effect between accounting profit and
taxable income (Abdul Wahab and Holland 2012a; Hanlon 2003). BTD is composed of
permanent differences and temporary differences. Results from prior studies show that
BTDs carry additional meaning of earning quality, i.e. earning growing or earning
persistence which may link to earning management (Graham et al. 2012). Blaylock et
al. (2012) show evidence of large BTDs relating to a lower level of earning and accruals
persistence. Abdul Wahab and Holland (2015) provide evidence that the persistence of
accounting earnings varied by the nature of BTDs and the difference of persistence is
sensitive to industrial types. Wilson (2009) documents a more direct relationship that
tax sheltering results in BTDs. Their result implies that either temporary or permanent
BTDs could reflect part of corporate tax avoidance levels. Lisowsky (2010) finds
consistent results that total BTDs are associated with the engagement of tax sheltering18.
Overall, since BTDs could be decomposed into less aggregate levels, the BTDs measure
could be used for empirical research with different focuses. Unlike ETR measures,
BTDs could not be directly made a comparison to any benchmark before matching with
similar firms (Abdul Wahab and Holland 2012a). Both BTDs and ETRs capture only
the non-conforming tax avoidance, since they are all deviations of accounting earnings
(Hanlon and Heitzman 2010).
Conformity tax avoidance transactions reduce tax liability together with reducing
accounting earnings. Conforming tax avoidance activities cannot be measured by
accounting income-based measures as they result in non-discretionary differences, e.g.
transactional changes that certain kinds of tax avoidance activities could cause. The
differences (which have long been neglected) that conformity activities could have
made on the firm level variation of tax avoidance are argued to be one of the causes of
the unexplained term in current tax avoidance model.
3.3.3 Tax shelter and other measures
Tax shelter proxy has a pure focus on the economic content of tax avoidance activities
regardless of the aggressiveness in financial reporting (Lisowsky 2010). Wilson (2009)
proposed a prediction model to measure the estimated probability of a firm engaging in
tax sheltering. Tax shelter proxies are expected to capture a more extreme extent of tax
avoidance activities (Wilson 2009; Chyz 2013). However, it may be plausible to expect
a stronger relationship using a proxy of more severe tax avoidance. The sample of
extant empirical research on tax sheltering is limited to US firms which were 18 Additionally, no significant relationship has been found between discretionary permanent BTDs (or long run cash ETR) and tax sheltering (Lisowsky 2010).
historically detected for engaging in tax sheltering activities (Graham et al. 2014;
Hanlon and Heitzman 2010). Empirical results would be difficult to generalize to
practices in other countries and to other firms not yet been found of engaging in tax
sheltering activities. Thus, tax shelter reflects aggressive tax avoidance activities but
the current method of measuring tax shelters may not be valid for non-US research as
well as research focusing on a general level of tax avoidance behaviours.
Other proxies (Table 1) like tax planning incentives measure tax avoidance at a
disaggregate level. By decomposing tax planning activities into temporary timing
differences, statutory rate differences and permanent differences, tax planning
incentives emphasize dynamic forms of tax avoidance (Abdul Wahab and Holland
2012a). Unrecognized tax benefits(UTB) is used as a measure of tax avoidance in
empirical tax avoidance research initially by Rego and Wilson (2012) in their UTB
prediction model. Prior research (Waegenaere et al. 2015) suggests that UTB is
sensitive to corporate tax avoidance level and greater UTB could be expected to
associate with more involvement of tax sheltering activities (Lisowsky et al. 2013).
However, an aggregate UTB alone could be less reflective on the tax avoidance since
the factors influencing UTB do not necessarily indicate that the weak tax position is
caused by tax planning behaviours.
3.3.4 Tax avoidance measure selection
One extreme of tax management could be completely risk-free activities, for example,
environmental taxes is designed to impose costs to those unfavourable behaviours, and
the tax authority encourages companies to avoid this kind of taxes. Research regarding
the rationale of corporate governance and tax avoidance activities, commonly adopts a
more aggressive end of the continuum (more risks induced)19 of tax management
activities. For example, to use measures of tax avoidance which would not be affected
by accounting profits, such as discretionary book-tax differences(DTAX) (Francis et al.
2016; Kubick and Lockhart 2016; Kim et al. 2011; Hasan et al. 2014) and tax
sheltering20dummy (Graham and Tucker 2006; Desai and Dharmapala 2006; Chyz et
al. 2013). However, prior research using tax sheltering measures adopts a sample of US
companies engaging in tax sheltering cases and the regression results for calculating
tax sheltering proxy is in turns not sensible to apply to UK companies. In terms of
DTAX, it is developed from the US sample which has accounts different from the UK
firms. For example, DTAX is the residual of the regression.
𝑃𝐸𝑅𝑀𝐷𝐼𝐹𝐹 = 𝛽0 + 𝛽1𝐼𝑁𝑇𝐴𝑁𝐺 + 𝛽2𝑈𝑁𝐶𝑂𝑁 + 𝛽3𝑀𝐼 + 𝛽4𝐶𝑆𝑇𝐸 + 𝛽1∆𝑁𝑂𝐿+ 𝛽1𝐿𝐴𝐺𝑃𝐸𝑅𝑀 + 휀
where data of current state income tax expense (CSTE) and the account of net operating
loss (NOL) are not applicable to UK firms. Therefore, measuring tax avoidance using
DTAX for UK sample would not be plausible either. Following prior theoretical models,
this research focuses on the condition effect of corporate governance and thus uses
current ETR, BTD and permanent BTD to measure corporate tax avoidance.
19 Tax avoidance which could always has an uncertain legal position since most companies would not take risk in obeying the law but from the view of tax authority, HMRC (2015), might behave in obeying the spirit of the law. 20 Graham and Tucker (2006) identify 44 tax shelter cases which contains tax shields such as lease-in/lease out (LILO), transfer pricing (with higher usage in their sample), tax havens, and corporate-owned life insurance.
Current ETR (Chen et al. 2010; Dyreng et al. 2008; Minnick and Noga 2010) is
measured by C_ETR:
𝐶_𝐸𝑇𝑅 =𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
𝑃𝑟𝑒𝑡𝑎𝑥 𝐼𝑛𝑐𝑜𝑚𝑒
The current tax expense (TAXS) (#01451) is the cash tax paid to tax authority displayed
in the income statement. The pre-tax income is profit before tax (PRT) (#01401) in UK
practices. Note that pre-tax income is the profit not including extraordinary items.
Following UK tax research of Brooks et al. (2016), the book-tax difference(BTD) is
defined as:
𝐵𝑇𝐷 =𝐵𝑜𝑜𝑘 𝑖𝑛𝑐𝑜𝑚𝑒 −
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑆𝑡𝑎𝑡𝑢𝑡𝑜𝑟𝑦 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝐿𝑎𝑔𝑔𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
Book income is represented by the pre-tax income (#01401). The statutory tax rate is
the main rate of UK corporate tax rate at financial year t. Total assets are the lagged
assets (TOA) (#02999) in the previous year of a company.
The permanent book-tax difference (PBTD) uses the total tax which arguably captures
a more aggressive form of corporate tax avoidance(Brooks et al. 2016). Deferred tax
(DEF) (#WC03263) is the timing effect of reporting revenue for tax and financial
reporting purposes. Permanent BTD is defined following Brooks et al. (2016) as:
𝑃𝐵𝑇𝐷 =𝐵𝑜𝑜𝑘 𝑖𝑛𝑐𝑜𝑚𝑒 −
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 + 𝐷𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑡𝑎𝑥𝑆𝑡𝑎𝑡𝑢𝑡𝑜𝑟𝑦 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝐿𝑎𝑔𝑔𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
3.4 Measuring firm value
Since the paper focuses on the shareholder’s valuation on corporate tax avoidance and
corporate governance, market capitalization is used as a proxy for firm value. Following
Brooks et al. (2016), market value (MV) is defined as:
𝑀𝑉 =𝐶𝑙𝑜𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 × 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
1,000,000
Based on the corporate finance literature on the determinants of firm value, this research
follows the standard by using Tobin’s q to measure firm value. Noted that there is no
strong theoretical background which suggests that Tobin’s q is important in representing
firm value with regard to tax avoidance research. This paper includes Tobin’s q since
there is empirical evidence that tax avoidance has an impact conditional to corporate
governance on the firm value measured by q (Desai and Dharmapala 2009). The
definition of q following Desai and Dharmapala (2009) and Chyz (2013) is the market
value of assets divided by book value of assets.
𝑞
=𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝐶𝑙𝑜𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 × 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡𝑠
4. Sample and data collection
The sample of listed firms in London Stock Exchange is defined as all constituents of
the FTSE 350 Index over the period of 2008 to 2015. The FTSE 350 is a capitalization-
weighted index of the largest 350 companies listing on the main market of the London
Stock Exchange. It compromises 350 companies which are the combination of the
largest 100 firms constituting the FTSE 100 Index and the next largest 250 firms
constituting the FTSE 250 Index. Table 2 contains the definition of variables in the
following discussion and specifies the database from which the whole sample is
obtained. Tax and corporate financial data are collected from Thomson Datastream with
some missing data supplemented from Compustat Global via Wharton Research Data
Services (WRDS). Corporate governance data is obtained from Thomson ASSET4 ESG
via Datastream and omitted data is supplemented from corporate annual reports.
Table 2 Definition of variables
Variables Definition Dataset
Firm value
q Tobin’s q Computed
MV Market capitalization(#WC08001/1,000) Thomson Datastream
Firm characteristics
SALES Sales=revenue(#WC01001)/1000 Thomson Datastream
FORIN Foreign income=foreign sales (#WC08731)/ total net
sales(#WC01001) Thomson Datastream
RD R&D=R&D expenditure (#WC01201)/ lagged total assets
(#WC02999)
Thomson Datastream/ Compustat Global
LEV Leverage(#WC08226) measured by D/E ratio=long term
debt (#WC03251)/ common equity (#WC02999)
Thomson Datastream/
Compustat Global
CAPIN Capital intensity=Gross machinery and equipment
(#18377)/ total assets (#WC02999) Thomson Datastream
Tax variables
C_ETR Current ETR Thomson Datastream
BTD Book-tax difference Computed
PBTD Permanent Book-tax difference Computed
Corporate governance
CG Corporate governance score Thomson ASSET4 ESG
BS Board size Thomson ASSET4 ESG
BI Board independence Thomson ASSET4 ESG/
Annual report
CCD CEO/Chairman duality Thomson ASSET4 ESG/
Annual report
OSTR Ownership structure Thomson ASSET4 ESG
CEOC CEO stock compensation Thomson ASSET4 ESG/
Annual report
TCOMP Total senior executives compensation Thomson ASSET4 ESG
The sample initially consists of 350 companies on FTSE 350 and is left with 256 after
excluding (i) companies from the financial industry. Companies in the final sample also
need to meet the criteria of (ii) having complete data from three sources, i.e. Thomson
Datastream, Compustat Global and companies’ annual reports, (iii) having non-
negative pre-tax income as well as non-negative current tax expense. The final sample
also (vi) exclude abnormal extreme values. After applying the criteria, it leads to a
sample with 304 observations for 38 companies at firm-year levels over the period of
2008 to 2015. Due to missing data of several corporate governance proxies, the sample
for testing Equation (3) is scaled down to 38 companies with 152 observations over the
period of 2010 to 2013.
Table 3 presents the descriptive statistics for all the sample of 304 firm-year
observations used in equation (a), (2) and (3), including the number of observations,
mean, standard deviation and five percentiles value of the variables. According to Table
3, both of the firm value proxies are skewed to the left with mean being larger than the
median.
Table 3 Descriptive statistics
Variable N Mean Std dev Percentiles
Min 25 50 75 Max
PRT(£m) 304 806.78 2075.56 14.80 90.55 161.82 667.75 19700.00
TAXS(£m) 304 225.01 656.77 4.10 20.10 39.03 157.95 5120.01
DEF(£m) 304 272.90 736.01 -812.20 -2.75 20.60 146.85 4297.00
TOA(£m) 304 7678.73 14100.00 100.92 860.20 2335.31 7526.13 86700.00
MV(£m) 304 8993.02 17877.29 225.27 923.42 2203.46 7114.87 130509.50
q 304 1.95 0.77 0.85 1.39 1.75 2.30 5.68
C_ETR 304 0.26 0.13 0.02 0.21 0.25 0.29 1.31
BTD 304 0.00 0.03 -0.14 -0.01 0.00 0.02 0.15
PBTD 304 -0.07 0.18 -0.73 -0.17 -0.05 0.02 0.77
SALES(£m) 304 5401.59 6974.13 103.82 1239.30 2507.25 9158.55 45502.38
FORIN 304 0.44 0.42 0.00 0.00 0.43 0.76 1.64
RD 304 0.01 0.01 0.00 0.00 0.00 0.00 0.07
LEV 304 0.85 1.82 -13.95 0.17 0.45 0.94 16.82
CAPIN 304 0.20 0.22 0.00 0.06 0.14 0.24 0.92
CG 304 80.46 13.16 32.74 75.29 83.99 89.98 96.93
BS 304 9.36 2.31 5.00 8.00 9.00 10.00 18.00
BI 304 51.67 20.62 0.00 46.72 55.56 62.66 93.31
CCD 304 0.02 0.14 0.00 0.00 0.00 0.00 1.00
OSTR 304 64.04 14.80 0.84 66.95 67.73 67.90 67.92
CEOC 304 0.76 0.43 0.00 1.00 1.00 1.00 1.00
TCOMP(£m) 304 10.83 22.41 0.00 2.67 5.18 10.65 330.50
𝐂_𝐄𝐓𝐑𝒕−𝟏 152 0.28 0.15 0.09 0.22 0.26 0.30 1.31
𝐂_𝐄𝐓𝐑𝒕−𝟐 152 0.29 0.14 0.09 0.23 0.28 0.31 1.31
𝐁𝐓𝐃𝒕−𝟏 152 0.00 0.03 -0.13 -0.01 0.00 0.02 0.06
𝐁𝐓𝐃𝒕−𝟐 152 0.00 0.03 -0.13 -0.01 0.00 0.02 0.15
𝐏𝐁𝐓𝐃𝒕−𝟏 152 -0.06 0.18 -0.65 -0.17 -0.05 0.02 0.77
𝐏𝐁𝐓𝐃𝒕−𝟐 152 -0.07 0.19 -0.73 -0.18 -0.05 0.02 0.77
Year 2008 2009 2010 2011 2012 2013 2014 2015
Statutory tax rate 0.29 0.28 0.28 0.27 0.25 0.23 0.22 0.20
The mean of cash effective tax rate (C_ETR) is 26% which is much higher than the
median (25%). The book-tax difference (BTD) has the same mean and median of a zero
BTD which implies that on average 38 firms pay all the taxes due. The value of each of
the tax avoidance measures (C_ETR, BTD and PBTD) has a wide range, which
indicates various practices of corporate tax avoidance behaviours. In terms of the
percentiles, current ETRs start to be higher than statutory tax rate at the 25% point. At
the highest 95%, BTD contains the amount as much as 15% of the firm’s total assets.
As shown in Table 3, the corporate governance score (CG) is skewed to the right with
a range from 32.74 to 96.93. The average board size is night directors of which slightly
above half (55.56%) are independence directors. The majority of firms in the sample
have two different individuals being the CEO and the chair of the board. According to
the scores of OSTR, there are powerful shareholders who hold a majority of votes for
the company. Most executive directors have compensation related to stock performance
and the total senior compensation paid at an average of £10,826,292.
5. Empirical results
Hypothesis H1 predicts a negative relationship between tax avoidance and firm value
since it assumes managerial diversion which makes a discount on shareholders’
valuation. The result of H1 is reported in Table 4 including the control variables. Since
the panel data could result in repeating features at firm levels, i.e. cross-sectional
dependence, the results based on standard errors are reported using robust (White)
standard errors clustered at the firm level to control for heteroscedasticity. To decide on
whether to include fixed or random effects, Hausman test is used to test the null
hypothesis that there is no unique error correlated with the estimates. If the result of
Hausman test shows a rejection of the null hypothesis, it suggests that the fixed effect
model should be used21. A further joint test is used for testing whether a year fixed effect
should be included. If the result of the test rejects the null hypothesis that dummies for
all years are jointly equal to zero, then time-fixed effects are needed22.
The model I, II and III are tested by the same hypothesis with different measures of tax
avoidance, using current ETR, BTD and permanent BTD. PBTD arguably captures a
more severe form of tax avoidance behaviours. C_ETR and BTD tend to cover a wider
range of tax avoidance activities and since C_ETR and BTD are nearly centrally
distributed (Table 3) the overall effect of tax avoidance may be offset. When the
dependent variable measuring the firm value is market capitalization, all three models
show a positive but not statistically significant effect of tax avoidance on firm value.
By conducting one-sided z tests for testing H1, the results of all models using MV (p-
value = 0.886, 0.931 and 0.513 respectively) reject the null hypothesis that there is a
negative relationship between tax avoidance and firm value.
Column 5, 6 and 7 in Table 4 present the coefficient estimates where Tobin’s q is used
21 The results of Hausman test for Equation(1) of model I, II and III are 0.3469, 0.2726 and 0.1963 respectively, which are all below 0.05 suggesting that there is no need to use fixed effect model. Consistent with the results of Hausman test, the results of Breusch-Pagan Lagrange multiplier (LM) tests also reject the null hypothesis that there is no significant difference across units and conclude that random effects is appropriate. 22 The results of the test show that Prob > chi2 = 0.0126, 0.0124 and 0.0022 and thus we reject the null and conclude that time fixed effects are needed.
as the dependent variable. Models using market capitalization as the dependent variable
present higher R-squares of 73%. However, models using q show a drop by 61% in R-
square. By comparing R-squared, regression models using q lose their explanatory
power. Similar to the prior results of model I and II, the overall effect of tax avoidance
proxies shows a positive but insignificant relationship with firm value. These results
are consistent with those of Desai and Dharmapala (2009) (tax avoidance measured by
BTD in their case). In contrast to H1, the coefficient of PBTD is significant at 10%
level, indicating that every 1% increase in permanent BTD (PBTD) leads to an increase
of 1.42 in Tobin’s q.
The coefficients of the control variables are, to a great extent, consistent with those
results of prior research. SALES is significantly positively related to firm value, which
is consistent with the findings of Lim (2011). Consistent with Kim et al. (2011) and
Abdul Wahab and Holland (2012), the coefficients of LEV (D/E ratio) are negative,
suggesting a higher debt finance could lower firm value. In the model I and II, the
coefficients of RD appear to have a significant impact on q suggesting that higher R&D
expense is related to higher firm value.
In sum, the tests of hypotheses reject H1 and the overall effect of tax avoidance
measures on firm value is positive and insignificant. This paper cannot find a negative
relationship between tax avoidance and firm value for the sample. The findings of
Equation (1) are consistent with recent UK evidence by Brooks et al. (2016) who
Table 4 Panel regression for the effect of tax avoidance on market capitalization and Tobin's q using robust
standard errors clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)
Dependent variable MV Tobin's q
Models I II III I II III
C_ETR -4088.07 -0.35
(-1.2) (-1.29)
BTD 30358.21 1.40
(1.48) (1.27)
PBTD -214.78 1.42***
(-0.03) (2.78)
SALES 1.910*** 1.93*** 1.92*** 0.00 0.00 0.00
(8.74) (9.03) (8.25) (-0.70) (-0.64) (-0.39)
FORIN -549.34 -1016.69 -152.81 -0.10 -0.11 -0.17
(-0.16) (-0.28) (-0.04) (-0.59) (-0.65) (-0.92)
RD -12959.51 -20346.43 -6730.01 5.85** 5.79** 5.00
(-0.19) (-0.28) (-0.1) (2.04) (1.94) (1.42)
LEV -186.36 -205.32 -153.53 -0.01 -0.01 -0.01
(-1.38) (-1.53) (-1.16) (-1.09) (-1.01) (-1.59)
CAPIN 362.49 1205.49 -379.05 0.50 0.50 0.47
(0.11) (0.33) (-0.12) (0.99) (0.93) (0.95)
Constant 300.68 -1064.95 -965.93 1.88*** 1.77*** 1.95***
(0.14) (-0.71) (-0.52) (10.88) (13.44) (12.67)
Random effect Y Y Y Y Y Y
Firm effect N N N N N N
Year effect Y Y Y Y Y Y
No.of obs 304 304 304 304 304 304
R-squared 0.743 0.736 0.745 0.137 0.127 0.0941
Wald 294.33*** 233.25*** 349.31*** 101.75*** 117.22*** 90.68***
*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.
employ data of firms from FTSE All-Share over the period of 1988 to 2014 and show
no link between corporate tax payments and the share price of a firm.
Equation (2) incorporates the interaction variables C_ETR*BI, BTD*BI and PBTD*BI
to test whether corporate governance mitigates the relationship between firm value and
tax avoidance. The results of Equation (2) using a dependent variable, MV and
corporate governance measure, BI, are presented in Table 5. The inclusion of the
corporate governance measure and the interaction term change the direction of the
previous positive relationship between tax avoidance and firm value. The interpretation
is limited since the previous relationships (see Table 4) are insignificant and the
coefficients of the interaction terms are all insignificant either (the results of one-sided
hypothesis test are P= 0.244, 0.167 and 0.412 respectively for the model I, II and III).
But the directions of the coefficients are consistent with H2 that 𝛽C_ETR∗BI is negative,
𝛽BTD∗BI and 𝛽PBTD∗BI are positive. R-squares of the regressions testing H1 and H2 are
similar23 which suggests that the incorporation of corporate governance has little
contribution.
Additional tests are conducted to further analyse the effect of corporate governance.
The whole sample is split into two subsamples of strong and weak corporate governance
firms (Desai and Dharmapala 2006; Desai and Dharmapala 2009; Abdul Wahab and
Holland 2012). Firms are separated by the median of BI at firm-year level. Firms with
high board independence are considered as having a strong corporate governance and
vice versa. For strong corporate governance group, the coefficient of C_ETR on MV is
negative and significant which can be interpreted as every 1% drop in current effective
tax rate resulting in an increase of £11,171.10 million in firm value (Table 5, the model
I). For weak-governed firms, the effect of C_ETR is insignificant and in an inverse
direction. This result is consistent with the findings of Desai and Dharmapala (2009)
and implies that shareholders perceive tax avoidance activities as value-added activities
in terms of well-governance companies but view tax avoidance activities as more risky
investments with regard to poor governance companies. In other words, the relationship
between MV and C_ETR is conditional upon the strength of corporate governance.
The tax avoidance (C_ETR) coefficients in two subsamples are significantly different
from each other (H0: -11171.10=473.19, p=0.043<0.05). The significant difference
between coefficients is robust to tax avoidance measure of BTD (H0: 47256.42=-
18143.99, P=0.050) but sensitive to the measure of PBTD (p=0.284>0.05). According
to the direction of the coefficient (Table 5), there is an inverse relationship between tax
avoidance and corporate governance for two subsamples, which indicates that the
overall effect of tax avoidance across firms may be offset. This result of the subsamples
may explain previous insignificant relationship at an aggregate level (Table 4). In short,
by splitting the sample this paper finds that the relationship between tax avoidance and
firm value tends to be positive for firms with strong corporate governance than for firms
with weak corporate governance, consistent with H2 and US findings of Desai and
Dharmapala (2009).
23 R-squares for model I, II and III in Equation (1) equal to 74.3%, 73.6% and 74.5% respectively (Table 4, column 1, 2 and 3) and R-squares of Equation (2) equal to 74.86%, 73.29% and 74.99% respectively (Table 5, column 1, 2 and 3).
Table 5 Panel regression for the mitigation effect of corporate governance on the relationship between tax avoidance and firm value (measured by Market capitalization) using robust standard
errors clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)
Dependent variable MV
Whole Sample Strong corporate governance Weak corporate governance
Models I II III I II III I II III
C_ETR 1739.83 -11171.10* 473.19
(0.21) (-1.77) (0.25)
C_ETR*BI -99.36
(-0.69)
BTD -16651.10 47256.42 -18143.99
(-0.53) (1.28) (-1.06)
BTD*BI 718.62
(0.97)
PBTD -2960.65 2179.96 -2882.02
(-0.29) (0.33) (-0.49)
PBTD*BI 47.35
(0.22)
BI 49.16 -7.76 26.40
(1.11) (-0.42) (1.19)
SALES 1.94*** 2.00*** 1.95*** 2.15*** 1.72*** 2.19*** 1.36*** 0.72* 1.31***
(9.29) (10.93) (8.41) (13.90) (6.15) (16.04) (4.14) (1.78) (4.28)
FORIN -669.22 -236.98 -290.64 -2951.04 -5563.64 -2994.07 9987.58 12150.93 9690.80
(-0.19) (-0.06) (-0.09) (-1.07) (-0.98) (-1.14) (0.85) (0.95) (0.87)
RD -819.16 -33087.13 2955.81 36725.90 -131454.20 74881.58 -83373.94 -108318.20 -77734.59
(-0.01) (-0.56) (0.05) (0.63) (-0.95) (1.37) (-0.72) (-0.90) (-0.70)
LEV -178.39 -161.74 -150.52 -257.46 -225.03 -212.59 407.93 547.52 447.28
(-1.33) (-1.07) (-1.18) (-1.51) (-1.33) (-1.32) (0.85) (0.86) (0.90)
CAPIN -168.05 1852.54 -755.59 3911.26 512.93 2618.12 -3029.85 -3877.14 -2853.12
(-0.05) (0.46) (-0.21) (0.80) (0.12) (0.47) (-0.81) (-0.85) (-0.81)
Constant -2559.91 -1310.59 -2536.57 3055.71 5699.73 963.42 -4054.57 -2872.41 -3866.98
(-0.95) (-0.80) (-1.47) (0.82) (1.53) (0.29) (-1.15) (-1.04) (-1.17)
Random effect Y Y Y Y N Y Y Y Y
Firm effect N N N N Y N N N N
Year effect Y N Y N N Y N Y Y
No.of obs 304 304 304 152 152 152 152 152 152
R-squared 0.7486 0.7329 0.7499 0.8681 0.8079 0.8658 0.4133 0.4672 0.4287
F-statistic/Wald 401.16*** 209.32*** 453.91*** 1338.84 *** 163.40*** 28193.84*** 25.33*** 88.07*** 19.58***
*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.
Furthermore, Equation (2) is also tested by an alternative dependent variable, Tobin’s q
(Table 6). Similar to previous findings, the results of the whole sample show little
evidence in supportive of the hypothesis. The coefficients of the tax avoidance
measures (C_ETR, BTD) and the interaction terms (C_ETR*BI, BTD*BI) are all
statistically insignificant when q is used as the proxy for firm value. In terms of model
III, given that the PBTD shows a positive impact and BI shows a negative impact on
Tobin’s q, the interaction terms PBTD*BI is significantly and negatively associated
with Tobin’s q which contradicts to the notion of agency theory.
The separation of the whole sample by strong and weak corporate governance firms
shows robust findings as previous results of subsamples (Table 6, strong and weak
corporate governance panel). There is a significant and positive relationship between
tax avoidance level and firm value for strong corporate governance firms and the
relationship is robust to different tax avoidance proxies24. In terms of weak corporate
governance firms, the coefficients of C_ETR and BTD imply that the relationship
between tax avoidance proxy and Tobin’s q is statistically insignificant. By comparing
the coefficients in two groups, this paper finds a significant difference (at 10% level) of
the coefficient of C_ETR between strong and weak corporate governance samples.
There is an exemption that the coefficient of PBTD in weak corporate governance group
is significant and positive. The previous positive and significant relationship between
Tobin’s and PBTD (Table 4) still holds for both groups of corporate governance strength.
Comparing the R-square of models using MV with those using q, the result shows a
significant drop in magnitude. It could be concluded that instead of using q as an
alternate dependent variable to test the robustness of the result, the inclusion of q is
problematic. It leads to models having little explanatory power. In addition, the result
of control variables shows inconsistency with previous findings.
Corporate governance score (CG) as another measure of corporate governance is also
used to test Equation (2) (Table 7) in addition to board independence (BI). The results
of Equation (2) are consistent with previous findings that at an aggregate level, there is
no significant impact of corporate governance on the relationship between tax
avoidance and firm value. R-squared for all the regressions using CG as the proxy of
corporate governance, are higher than the R-squared of regressions using BI (Table
4&5). The increase in R-squared indicates that the measure of CG has better
explanatory power in the model.
With regard to the test of H3, the following section conducts multivariate analysis to
test the sensitivity of tax avoidance to various corporate governance mechanisms. Table
8 reports the estimation results of Equation (3) and the results after controlling for
endogeneity problem which commonly occurs in corporate governance research. Noted
that diagnostics tests are used to decide whether to include random or fixed effect within
the regression and whether time fixed effect is needed (see Appendix 2). Following
Wintoki et al. (2012) and Minnick and Noga (2010), this paper controls for the
endogeneity by including lags of the main variable of interest. Prior literature suggest
that past performance is useful in measuring the historical managerial performance as
well as predicting the future governance features (Minnick and Noga 2010). Thus using
a lagged variable is argued to be the most appropriate approach to control for the
endogeneity problem (Wintoki et al. 2012). 24 The null hypothesis that tax avoidance is positively related to firm value is one-sided test, e.g.H0: β𝐶_𝐸𝑇𝑅 < 0, H0: β𝐵𝑇𝐷 > 0 and H0: β𝐵𝑇𝐷 > 0. The results is p=0.039<0.05, p=0.082<0.10 and p=0.022<0.05 respectively.
Table 6 Panel regression for the mitigation effect of corporate governance on the relationship between tax avoidance and firm value (measured by Tobin’s q) using robust standard
errors clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)
Dependent variable Tobin’s q
Whole Sample Strong corporate governance Weak corporate governance
Models I II III I II III I II III
C_ETR -0.72 -0.97* -0.09
(-0.84) (-1.88) (-0.47)
C_ETR*BI 0.01
(0.57)
BTD 0.00 1.87* 0.27
(0.00) (1.40) (0.11)
BTD*BI 0.02
(0.50)
PBTD 2.56*** 1.22*** 2.67**
(2.92) (2.02) (2.10)
PBTD*BI -0.02*
(-1.78)
BI -0.01 0.00 -0.01**
(-1.43) (-1.56) (-2.15)
SALES 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
(-0.82) (-0.81) (-0.66) (-1.57) (-1.33) (-1.26) (0.43) (0.45) (1.01)
FORIN -0.07 -0.08 -0.10 -0.11 -0.03 -0.12 -0.35 -0.34 -0.26
(-0.41) (-0.46) (-0.55) (-0.48) (-0.15) (-0.56) (-1.39) (-1.40) (-0.57)
RD 4.60 4.40 3.46 -21.68 3.62 3.24 4.99 5.01 -5.90
(1.50) (1.44) (0.95) (-1.44) (0.58) (0.43) (1.01) (0.97) (-0.57)
LEV -0.01 0.00 -0.01** -0.01 -0.01* -0.01*** 0.05 0.05 0.01
(-1.24) (-1.04) (-2.27) (-1.32) (-1.81) (-2.34) (0.86) (0.88) (0.25)
CAPIN 0.59 0.61 0.56 1.11 0.78 0.80 0.17 0.17 -0.37
(1.15) (1.12) (1.13) (1.04) (0.91) (1.05) (0.26) (0.25) (-1.20)
Constant 2.15*** 1.96*** 2.23*** 2.35*** 2.01*** 2.19*** 1.57*** 1.54*** 1.81***
(7.53) (10.39) (9.39) (7.41) (8.60) (9.47) (7.36) (8.43) (7.77)
Random effect Y Y Y N Y Y Y Y N
Firm effect N N N Y N N N N Y
Year effect Y Y Y N Y Y Y Y Y
No.of obs 304 304 304 152 152 152 152 152 152
R-squared 0.1218 0.1133 0.1026 0.0013 0.1128 0.0956 0.2083 0.2076 0.0447
F-statistic/Wald 126.44*** 136.35*** 121.54*** 1.56 90.20*** 88.89*** 280.92*** 359.23*** 7.54***
*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.
Table 7 Panel regression for the mitigation effect of corporate governance (measured by corporate
governance score) on the relationship between tax avoidance and firm value using robust standard errors
clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)
Dependent variable MV Tobin’s q
Models I II III I II III
C_ETR 11150.59 -1.12
(0.53) (-0.59)
C_ETR*CG -186.44 0.01
(-0.66) (0.39)
BTD -39229.76 -5.10
(-0.55) (-0.96)
BTD*CG 916.73 0.09
(0.86) (1.15)
PBTD 20461.93 2.84
(1.19) (1.44)
PBTD*CG -251.66 -0.02
(-1.45) (-0.67)
CG -33.08 -76.17*** -109.54*** -0.01 0.00 -0.01
(-0.42) (-3.30) (-3.04) (-0.83) (-1.14) (-1.46)
SALES 1.89*** 1.90*** 1.91*** 0.00 0.00 0.00
(9.44) (9.97) (9.05) (-0.73) (-0.70) (-0.41)
FORIN -583.34 -1053.51 -447.90 -0.11 -0.11 -0.19
(-0.17) (-0.30) (-0.13) (-0.62) (-0.63) (-1.01)
RD -7701.09 -19821.59 1046.46 6.09** 5.61* 5.25
(-0.11) (-0.27) (0.02) (2.14) (1.91) (1.49)
LEV -173.04 -204.96 -157.29 -0.01 -0.01 -0.01*
(-1.37) (-1.60) (-1.21) (-1.17) (-1.08) (-1.70)
CAPIN 355.43 1096.89 -1143.96 0.51 0.51 0.43
(0.11) (0.31) (-0.36) (0.99) (0.95) (0.83)
Constant 1908.06 4357.33 7102.47* 2.34*** 2.00*** 2.35***
(0.33) (1.63) (1.72) (4.02) (9.19) (6.57)
Random effect Y Y Y Y Y Y
Firm effect N N N N N N
Year effect Y Y Y Y Y Y
No.of obs 304 304 304 304 304 304
R-squared 0.7561 0.7474 0.7555 0.1559 0.1479 0.1091
F-statistic 471.72*** 343.83*** 446.96*** 112.46*** 162.39*** 103.11***
*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.
With regard to board structure, board size is found to be negatively related to PBTD
and the result is robust after controlling for endogeneity (Table 8). The coefficient of
BS is statistically significant which implies that to add 1 more person to the board leads
to PBTD decrease by 1% of the total assets. The findings are consistent with the
evidence of Cheng (2008) that larger board is related to more stable firm value. There
is a weak but significant relationship between CCD and tax avoidance measures,
indicating that a firm has a lower level of tax avoidance if the CEO and the chair of the
board are two different people. This result contradicts to previous US findings of
Minnick and Noga (2010) and the notion that stronger corporate control relates to lower
tax liabilities since firms may have a higher level of monitoring for tax avoidance
strategies. OSTR has significant coefficients but the effect of OSTR on tax avoidance
is weak since the magnitude of the coefficient converges to zero. Among all the
corporate governance characteristics, incentives compensation appears to have the
strongest effect in driving the decision of corporate tax avoidance strategies. The
coefficient of CEOC is significant for both C_ETR and BTD.
In terms of CEO compensation, on average firms with CEO compensation relating to
stock returns (CEOC) result in a lower C_ETR and higher BTD. The result is consistent
with H3 that stronger corporate governance aligns the interests of managers with the
interests of all the shareholder’s. According to Table 8, total senior managerial
compensation (TOMP) has a slightly positive and significant relationship with PBTD.
This result is consistent with the notion that higher compensation leads to fewer
incentives for manager extracting rents. Overall, the empirical results show that
incentives compensation is most sensitive to the decision of corporate tax avoidance
level. Higher corporate governance imposes stronger internal control which aligns the
interest of managers with the interest of shareholders. However, according to the
regression result of Equation (3), corporate governance characteristics some of which
have an uncertain effect on firm performance appear to have a various effect on tax
avoidance. According to the findings of this paper, larger BS and the separation of
CEO/Chair lead to lower level of tax avoidance. On the other hand, compensation
incentives encourage managers to get more involve in tax avoidance activities (Rego
and Wilson 2012; Minnick and Noga 2010; Kubick and Lockhart (2016).
Table 8 Panel regression for the effect of corporate governance characteristics on tax avoidance activities using
robust standard errors clustered at firm level (with tax avoidance measures: current ETR, BTD, Permanent BTD)
Dependent
variables C_ETR BTD PBTD C_ETR BTD PBTD
Models Equation (3) Equation (3) controlled for endogeneity
CG 0.00*** 0.00*** 0.00 0.00 -0.02 0.00
(-3.03) (3.30) (0.38) (-0.59) (-2.30) (0.26)
BS 0.01 0.00* -0.01** 0.00 0.04 -0.01**
(1.18) (-1.82) (-2.43) (-0.51) (2.40) (-2.19)
BI 0.00 0.00 0.00 0.00 0.01 0.00*
(1.10) (-1.46) (-1.53) (0.69) (1.90) (-1.97)
CCD 0.04** -0.03*** -0.01 0.04 0.00** -0.01
(2.25) (-3.80) (-0.69) (1.28) (0.02) (-0.21)
OSTR 0.00** 0.00** 0.00* 0.45 0.00** -0.01
(-2.30) (2.10) (1.89) (1.64) (-0.68) (-0.15)
CEOC 0.01 0.00 0.04* -0.07** 0.03* 0.02
(0.60) (0.00) (1.69) (-2.42) (1.63) (0.97)
TCOMP 0.00 0.00 0.00* 0.00 0.53 0.00*
(-0.17) (-0.18) (-1.81) (-1.19) (1.35) (-1.79)
SALES 0.00 0.00 0.00 0.00 0.00 0.00
(0.44) (-0.68) (0.24) (0.66) (2.49) (-0.18)
FORIN -0.03 0.01 -0.03 -0.20* -0.02 -0.02
(-0.97) (1.21) (-0.57) (-1.86) (-0.40) (-0.29)
RD 0.88 -0.16 -0.23 -1.46 -0.02 -1.33
(1.36) (-0.71) (-0.23) (-1.06) (-2.30) (-0.83)
LEV -0.01*** 0.00*** 0.00*** -0.01** 0.04** 0.01***
(-3.43) (3.87) (2.80) (-2.68) (2.40) (2.72)
CAPIN 0.01 0.00 0.07 0.05 0.01 0.23*
(0.21) (-0.25) (0.91) (0.31) (1.90) (1.87)
𝐂_𝐄𝐓𝐑𝒕−𝟏 -0.11
(-1.01)
𝐂_𝐄𝐓𝐑𝒕−𝟐 -0.08
(-1.30)
𝐁𝐓𝐃𝒕−𝟏 0.12
(0.66)
𝐁𝐓𝐃𝒕−𝟐 -0.01
(-0.07)
𝐏𝐁𝐓𝐃𝒕−𝟏 0.23
(1.30)
𝐏𝐁𝐓𝐃𝒕−𝟐 -0.08
(-0.61)
Constant 0.35*** -0.05* -0.01 -28.15 -2.42** 0.54
(5.21) (-1.89) (-0.06) (-1.61) (-2.43) (0.21)
Random effect Y Y Y N N N
Firm effect N N N Y Y Y
Year effect Y N N Y N N
No.of obs 152 152 152 152 152 152
R-squared 0.2134 0.3265 0.0827 0.0129 0.0773 0.0171
F-statistic/Chi-
statistic 71.02*** 105.49*** 43.88*** 7.17*** 4.53*** 5.23***
*, ** and *** denote statistical significance at the 10%, 5% and 1% levels.
6. Conclusion
This study conducts an examination under UK setting and it analyses the shareholders’
valuation on tax avoidance activities and the mitigation effect of corporate governance.
The empirical results show no significant relationship between various tax avoidance
proxies and firm value, which is in contrast to the previous US evidence. However, the
findings of Equation (1) are consistent with recent UK evidence by Brooks et al. (2016).
Under agency framework, tax avoidance can lead to higher firm value for strong
corporate governance firms and result in lower firm value for weak governance firms.
This paper then examines the role of corporate governance, whether corporate
governance eliminates agency costs and affects the relationship between tax avoidance
and firm value. The result of this paper shows that corporate governance has the
mitigation effect on the agency problems relating to tax avoidance at a disaggregate
level. By splitting the whole sample into strong corporate governance group and weak
corporate governance group, this paper finds that the relationship between tax
avoidance and firm value tends to be positive for firms with strong corporate
governance and less significant for firms with weak corporate governance. The
empirical result also shows that incentives compensation is most sensitive to the
decision of corporate tax avoidance level. The characteristics of board structure are
effective in controlling for managers’ action regarding tax avoidance strategies.
Although this paper does not find any negative relationship between tax avoidance and
firm value, one reason may be that tax avoidance measures of current ETR, BTD and
PBTD could impose measurement error since taxes is not often a dominant factor of a
decision. Other determinants e.g. earnings management may affect the quality of tax
avoidance measures. Another reason may be attributed to the changing attitude of tax
avoidance in the UK environment. The general public is expecting more transparency
and social responsibility for business activities and tax management, which indicates
that the reputation costs for corporate tax avoidance behaviours are increasing. Large
businesses are more likely to react according to their social responsibility. This paper
may thus have sample bias since it employs the data from the UK’s largest 350 firms
listed on London Stock Exchange. Therefore, instead of limiting to the shareholders’
aspect of tax avoidance valuation effect, perhaps future research could explore other
groups of interest in affecting the tax avoidance decisions. In terms of agency costs that
tax avoidance may incur, the purpose of increased corporate governance is to maximize
shareholders’ wealth, and different corporate governance mechanisms may result in
different effect on tax avoidance. As shown in the empirical findings, the overall effect
of corporate governance on the relationship between tax avoidance and firm value can
be insignificant. However, the dynamic nature of the interplay between corporate
governance mechanisms and tax avoidance suggests that future research could explore
focusing on the various effect between corporate governance and corporate tax
avoidance decisions.
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