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The Accounting Review: Long-Run Corporate Tax Avoidance

Authors: Scott D. Dyreng, Michelle Hanlon, and Edward L. Maydew
January 2008

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Scott D. Dyreng, Michelle Hanlon, and Edward L. Maydew say they have developed a measure to investigate the extent to which some firms are able to avoid taxes over periods as long as ten years, and how predictive one-year tax rates are for tax avoidance in the long run.

We develop and describe a new measure of corporate long-run tax avoidance. We use this measure to investigate (1) the extent to which some firms are able to avoid taxes over periods as long as ten years, and (2) how predictive one-year tax rates are for tax avoidance in the long run. We measure tax avoidance as the ability to pay a low amount of cash income taxes (as opposed to GAAP tax expense that one would find on a firm's income statement) relative to corporate pre-tax earnings. We are interested in firms' global tax avoidance, i.e., the combined effects of income taxes in all jurisdictions in which the firm does business. Accordingly, we compute our cash effective tax rate measure as the ratio of cash taxes paid across all jurisdictions (domestic, foreign, and state and local) to the firm's worldwide pretax book income. We measure the cash effective tax rate for firms over periods ranging from one to ten years—with the ten-year measure being the sum of cash taxes paid over ten years divided by the sum of pretax book income over those same ten years. We refer to the ten-year rate as the ''long-run cash effective tax rate.

It is important to emphasize that tax avoidance does not necessarily imply that firms are engaging in anything improper. There are numerous provisions in the tax code that allow and/or encourage firms to reduce their taxes. In addition, in practice there are many areas in which the law is unclear, particularly for complex transactions, and firms may take positions on their returns in which the ultimate tax outcome is uncertain. For purposes of this study, we define tax avoidance broadly as anything that reduces the firm's cash effective tax rate over a long time period, i.e., ten years. Thus, our measure will reflect both tax reductions that are squarely in compliance with the law as well as those that result from gray-area interpretations.

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