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Review of Accounting Studies

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17-09-2018

Societal trust and corporate tax avoidance

Authors: Kiridaran Kanagaretnam, Jimmy Lee, Chee Yeow Lim, Gerald Lobo

Published in: Review of Accounting Studies | Issue 4/2018

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Abstract

Using an international sample of firms from 25 countries and a country-level index for societal trust, we document that societal trust is negatively associated with tax avoidance, even after controlling for other institutional determinants, such as home country legal institutions and tax system characteristics. We explore the effects of two country-level institutional characteristics—strength of legal institutions and capital market pressure—on the relation between societal trust and tax avoidance. We find that the relation between trust and tax avoidance is less pronounced when the legal institutions in a country are stronger and is more pronounced when the capital market pressure is stronger. Finally, we examine the relation between societal trust and tax evasion, an extreme and illegal form of tax avoidance. We show that societal trust is negatively related to tax evasion and the negative relation is less pronounced when legal institutions are stronger.

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Examples of aggressive tax planning include taking the more favorable tax position where the tax law is ambiguous or open to interpretation, structuring complex transactions where the only motivation for the transaction is tax savings, and other tax sheltering transactions, such as lease-in, lease-out, and contingent-payment installment sales. We refer to these forms of aggressive tax planning as “tax avoidance” in the rest of this paper.

An example of such punishments includes being labeled as a “poor corporate citizen” (Bankman 2004), which might hurt product market outcomes (e.g., Hanlon and Slemrod 2009; Hardeck and Hertl 2014).

Evidence suggests that there are reputational costs associated with tax avoidance (e.g., Hanlon and Slemrod 2009; Graham et al. 2013; Hardeck and Hertl 2014).

Atwood et al. (2012) define PTEBX as pre-tax earnings before exceptional items (data item 57 from the Legacy Global Compustat database) instead of pre-tax income less special items (PI minus SPI from the new Global Compustat database). Because the former variable is only available up to 2007, we modify the Atwood et al. measure of PTEBX so as to extend our sample period to 2014. Our results are robust to using the Atwood et al. measure of PTEBX and ending our sample period in 2007.

We also note that, if our operational measure of tax avoidance is not very effective in capturing more aggressive tax planning, it will reduce the power of our tests and bias against finding results consistent with our hypothesis. Moreover, we attempt to control for benign tax planning, such as research and development tax credits and interest deductibility of debt, by including research and development intensity and leverage ratio as controls.

We define industries using the classification in Frankel et al. (2002).

We hand collect each country’s annual statutory corporate tax rate and whether the tax system is worldwide or territorial from various sources, such as Ernst and Young’s Worldwide Corporate Tax Guide, KPMG’s Corporate and Indirect Tax Rate Survey, PwC’s Worldwide Tax Summaries, and PwC’s “Evolution of Territorial Tax Systems in the OECD” report.

Atwood et al. (2012) use the country average of managers’ variable pay as a percentage of management compensation from Towers Perrin (2005), which reports the pay components of CEOs across 26 countries. We do not have access to data from the Towers Perrin’s report. Instead, we obtain equity-based compensation data from Bryan et al. (2010) who provide average equity-based compensation for 43 countries. The use of this variable also explains the differences in the countries represented in our sample of 25 countries and the Atwood et al. (2012) sample of 22 countries.

The impact of a one standard deviation increase in societal trust (TRUST) on tax avoidance (TAXAVOID) is computed as −0.105 (coefficient on TRUST in Table 3) × 0.115 (the sample standard deviation of TRUST in Table 2) ÷ 0.136 (the sample mean of TAXAVOID in Table 2) = 8.9%.

Data on foreign income taxes (data item 51 from the Legacy Global Compustat) is only available to 2007.

As suggested by Larcker and Rusticus (2010), we formally test the strength of our instrumental variable by computing the partial F-statistic for the instrument used in the first-stage regression. The partial F-statistic is 7736.27, much higher than the minimum benchmark of 8.96 for a model with one instrument, as reported by Larcker and Rusticus (2010). Therefore we conclude that our model does not suffer from a weak instrument problem.

Of the 25 countries covered in the tax avoidance analysis in Table 1, only 10 countries are covered in the tax evasion analysis in Table 7 (Chile, Germany, Indonesia, Korea, Mexico, Peru, the Philippines, South Africa, Spain, and Turkey).

The impact of a one standard deviation increase in societal trust (TRUST) on tax evasion (EVADE_RATIO) in Column 1 is computed as −8.735 (coefficient on TRUST in Table 8) × 0.108 (the sample standard deviation of TRUST, untabulated) ÷ 18.861 (the sample mean of EVADE_RATIO, untabulated) = 5.0%.

We do not examine the moderating role of capital market pressure (H2b) because the sample firms are predominantly private firms that do not face capital market pressures to evade taxes.

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Title: Societal trust and corporate tax avoidance
Authors: Kiridaran Kanagaretnam
Jimmy Lee
Chee Yeow Lim
Gerald Lobo
Publication date: 17-09-2018
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 4/2018
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-018-9466-y

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