A research on tax avoidance, cost of debt and IRS audit: evidence
from listed firms in America
ID: 10826750
Feng Shuchen
2015.06.22
MSc Accountancy & Control, variant Accountancy
Amsterdam Business School
aculty of Economics and Business, University of Amsterdam
Supervisor: Mr. Wim Janssen
A research on tax avoidance, cost of debt and IRS audit: evidence
from listed firms in America
Statement of Originality:
This document is written by student [Shuchen Feng] who declares to take
full responsibility for the contents of this document. I declare that the text
and the work presented in this document is original and that no sources
other than those mentioned in the text and its references have been used
in creating it. The Faculty of Economics and Business is responsible
solely for the supervision of completion of the work, not for the contents.
Abstract This paper studies the impact that tax avoidance generates on cost of debt for American listed firms. As the main provider of debt financing, debtholders should wisely measure and make a trade-off between the cost and benefit of tax avoidance, and take them into the decision of credit pricing decisions (El Ghoul et al. 2011). The paper finds that the higher level of tax avoidance of the firm, the lower cost of debt the firm will possess. Furthermore, taking the share proportion owned by institutional investors as the proxy of corporate governance quality, the paper finds that IRS audits exert a strengthen function in the negative relationship between tax avoidance and cost of debt, and this result is especially significant in companies having lower corporate governance. This paper provides a empirical proof for debtholders to better know economic consequences of tax avoidance, bring monitoring function of IRS audits into play and understand the substitute function between IRS audits and internal controls.
Table of content
I. Introduction ... 6
II. Literature Review and Hypothesis ... 9
III. Research Methodology ... 15
3.1 Data Source and Sample Selection ... 15
3.2 Research Design ... 16
IV. Empirical Results analysis ... 21
4.1 Description Statistic Analysis ... 21
4.2 Multiple Regression Analysis ... 22
V. Conclusion and Limitation ... 29
VI. References (MLA): ... 32
I. Introduction
This paper investigates the impact of internal Revenue Service (IRS) monitoring on tax avoidance and its interaction effect with debt financing cost of American listed firms. According to the Demos, Tax evasion will cost the U.S. government $305 billion in 2010 and has cost $3 trillion over the past decade. Tax evasion also costs state treasuries billions of dollars. Every tax filer will pay an extra $2,200 in 2010 to make up for the funds lost to tax cheating. Even modest success in reducing tax evasion would free up significant new resources for spending or deficit reduction (Taxes Matter: 2011). Of course, firms are naturally willing to lower their taxes this benefits shareholders as the residual claimants (Mills, 1996; Mills et al. 1998)
From the national perspective, tax revenue, as a major source of revenue, is an important way for the country to share corporate wealth tax. And from the business perspective, maximizing the shareholder after-tax income is inevitably achieved through the use of financial or business activities tax avoidance arrangement. However, in fact, can tax avoidance increase shareholder income literally? From the perspectives of reality, the direct consequence of corporate tax avoidance is to increase the cash flow for firms, improving mobility and flexibility of the firm. Desai et. al 2006 and Desai et. al (2007) have found that, in companies having separation of ownership and management, and those having highly-centralized equity ownership, top management and other insiders are more able to use ways such as complex and complicated transactions with related parties to avoid tax (e.g., Shleifer and Vishny, 1986; Chung et al., 2002; Bhojraj and Sengupta, 2003; Hartzell and Starks, 2003; Desai and Dharmapala, 2009). While in fact, insiders are conducting activities that may harm the shareholders’ interests (Desai and Dharmapala, 2006; Desai et al., 2007; Desai and Dharmapala, 2009; Wilson, 2009) . In other words, there are agency costs existing in these companies (Desai et. al, 2007). That is to say, benefits generated through tax avoidance can be the objectives that top management and big
shareholders tend to occupy (Desai and Dharmapala, 2006, 2009; Desai et al., 2007; Wilson, 2009; Shackelford and Shevlin, 2001).
The auditing scandal of Anderson in 2002 emphasizes the significance and on tax audit of listed firms. In 2002, Anron was found fake increase in after-tax investment and was thus both Anron and Anderson were faced with judicial review. Although this is a minority case, it is real that under the cover of tax avoidance, company managers are more concentrate on benefits transfer, which definitely hurt the shareholder and debtholders’ benefit (Congressional Joint Committee on Taxation, 2003; Roach, Brian, 2003). Consequently, whether tax audit and administration activities and how they affect the economic consequences of corporate tax avoidance? In firms with different levels of corporate governance, whether economic consequences of corporate tax avoidance have differences? As a result, this paper is motivated to illustrate the impact of tax avoidance on the cost of debt and its effect with tax audit.
The first objective of this paper is to investigate whether tax avoidance reduces the cost of debt, by including the implementation of IRS (Internal Revenue Services). The cost of the debt of a firm is determined by the characteristics of the firm and those of the bond issue that affect default risk, agency costs, and the information asymmetry problems (Bhojraj and Sengupta, 2003). Graham and Tucker (2006) suggest that tax-favored activities, such as tax shelters and tax avoidance, are a substitute for the use of debt. They examine 44 tax shelter cases that were issued as a Notice of Deficiency by the Internal Revenue Services (IRS). These cases indicate that firms use less debt when they engage in tax sheltering. If tax avoidance is a substitute for the use of debt (Graham and Tucker, 2006), it could increase financial slack, reduce expected bankruptcy costs, enhance credit quality, lower default risk, and therefore reduce the cost of debt (Graham and Tucker, 2006; Lim, 2010).
methods and tax shelters that are occasionally of questionable legality to minimize tax liability. In other words, the tax avoidance measure conceptually captures the cumulative number of transactions to minimize tax liabilities (Desai et al, 2006).
The second objective is to investigate the agency theory on the relationship between tax avoidance and cost of debt by examining the effect of tax audit quality on the relationship. From an agency perspective, tax avoidance would reduce the transparency of firms, and permit managers with the opportunity to extract rents from outside investors, creating a shield for managerial opportunism and the diversion of rents (Desai and Dharmapala, 2006; Desai et al., 2007; Desai and Dharmapala, 2009). American firms are expected to have strong incentives to increase financial income and decrease taxable income. Private debt financing decision depends on the judgment of creditors, who usually have relatively stronger ability to gain private information and post-supervision capabilities, such as bank loans (MacKie-Mason, 1990; Trezevant, 1992). Hence, whether hidden information by corporate tax avoidance will be included into debt financing decisions is a theoretical and practical significance of research in the field. The contribution of this paper is: from the point of company's debt financing costs, the paper mainly examines the economic consequences of tax avoidance behavior, focusing on the impact of tax avoidance on the cost of debt and its interaction effect with tax audit, and providing Desai et.al (2007)’s theoretical model with American empirical evidence.
The paper studies the influence of tax avoidance on cost of private debt financing for American listed companies. As main providers of debt financing, the debt-holders have to trade-off the costs and benefits of tax avoidance and put it into debt pricing decision (Ashbaugh-Skaifea et al. (2006). This paper will investigate the agency theory on the relationship between tax avoidance and cost of debt by examining the effect of tax audit quality on the relationship.
debt the firm will possess. Furthermore, taking the share proportion owned by institutional investors as the proxy of corporate governance quality, the paper finds that IRS audits exert a strengthen function in the negative relationship between tax avoidance and cost of debt, and this result is especially significant in companies having lower corporate governance. The contribution of this paper is: from the point of company's debt financing costs, the paper mainly examines the economic consequences of tax avoidance behavior, focusing on the impact of tax avoidance on the cost of debt and its interaction effect with tax audit (Shackelford and Shevlin 2001; Graham 2008; Desai and Dharmapala 2010), and providing Desai et.al (2007)’s theoretical model with American empirical evidence.
II. Literature Review and Hypothesis
In this section, the paper will give a structure of prior research to develop the hypothesis that IRS monitoring lowers the level of firms’ tax avoidance.
The research of Hanlon and Heitzman(2010), we find that there were various definition of tax avoidance and that corporate governance can affect the decision making of debt-holders through tax avoidance behavior (Carey et al., 1993), but without the knowledge of how and to what extent of the impact, and there is limited research at that time relating to tax avoidance to ownership structure and bondholder-stockholder conflicts. Furthermore, previous analyses of tax avoidance and evasion have emphasized the behavior of individuals (as in the literature reviewed in Slemrod and Yitzhaki, 2002), instead of corporations. Consequently, this paper is motivated to answer the call for future study on the relationship between corporate structure, tax avoidance and debt financing cost of Hanlon and Heitzman(2010) focusing on a more detailed and particular definition of tax avoidance and fill in the literature gap of lacking in study in corporation behaviors.
Hanlon and Heitzman(2010) provide a careful and thorough review and summary of tax research focusing on four main areas of literature: (1) the informational role of income tax expense reported for financial accounting, (2) corporate tax avoidance, (3) corporate decision-making including investment, capital structure, and organizational form, and (4) taxes and asset pricing. From the research of Hanlon and Heitzman(2010), we find that there were various definition of tax avoidance and that corporate governance can affect the decision making of debt-holders through tax avoidance behavior, but without the knowledge of how and to what extent of the impact, and there is limited research at that time relating to tax avoidance to ownership structure and bondholder-stockholder conflicts. Moreover, the tax minimize considerations and actions are believed to have become so prevailing that, according to Slemrod and Yitzhaki(2002), they now constitute the most serious compliance issue threatening the American tax system today. Here, I define tax avoidance as the reduction in income tax resulted by tax evasion activities.
The focus of former literatures that are aiming to study tax avoidance can be divided into two categories: one is to discuss the determinants of tax avoidance, while the other is to study the economic consequences of companies’ tax avoidance activities. In fact, these two types of research are similar to each other, just like two sides of one coin. The determinants of tax avoidance have been widely researched by the field of public finance and economics (Slemrod and Yitzhaki, 2002). Assuming that the tax avoidance strategies of company is exogenous, the direct economic consequence of company tax avoidance activity is the cash flow and shareholder equity are increased, through deducting costs, which are not deductible in other cases, from total income; on the other hand, the indirect effects of the company tax avoidance activities are, the increase in pre-tax deductible items will reduce the company 's dependence on debt avoidance, and thus affecting the company's decisions on capital structure (Graham and Tucker, 2006). The underlying side effect of companies’ tax avoidance activities can be that, the probability of incurring the audit from IRS, the tax department of
government will increase, resulting coresponding tax penalty costs, harming the company’s reputation, increasing future debt financing costs, and finanly giving negative impact on shareholders’ interests (Molina, 2005). As a result, there are costs and risks existing in the process of tax avoidance. However, generally the ecnomic profit is bigger than those costs, and this is also the reason why company tax avoidance activities exist commonly.
Apart from using the debt interests to deduct the tax, tax avoidance are most usually realized by companies through non-debt form (DeAngelo and Masulis, 1980). Within the permitted scope by tax rules and regulations, the corporate that are responsible for taxes are able to use legitimate ways, formally legal operation and financial activity arrangements to reduce taxable income amount. For example, register new offshore companies overseas, take related transactions or transfer pricing strategies, establish political relations, depreciation policies, investment tax credits, and use the profit in subsequent years to credit the loss of this year, etc., those strategies are all contribute to achieving the goal of reduce or even avoid tax burden for the company. In general, these strategies are called “non-debt tax avoidance”. Research of De Angelo and Masulis(1980) points out that this form of tax avoidance activitise will generate Crowding Out Effect of tax avoidance through debt, and thus decrease the effectiveness and efficiency of debt tax avoidance, ultimately weakening the attractiveness of tax avoidance through debt. Similarly, it is found that companies can get tax credits are less likely to avoid tax through deducting tax by debt, and these companies are always having lower debt-asset ratio (Dhaliwal er.al, 1992). Also, the research done by Graham et al (2006), Wilson(2009) and Lisowsky(2010) all support the conclusion. This is because non-debt tax avoidance is able to reduce the company’s demand for debt financing, increase the financial flexibility, lower the financial risk of bankruptcy liquidation and eventually reduce the costs of debt financing (Kim, 2011). Moreover, Jensen and Meckling (1976) states that, there can be agency costs existing in corporate debt, such as alternative assets. Furthermore, reducing dependent on debt, to a certain degree, can reduce the agency conflict from
shareholders and debthoders. As a result, from perspectives of the investors, advantages and merits of tax avoidance can be summarized as increases in cash flows and debt agency cost savings, while the costs and disadvantages of tax avoidance is manifested in the potential benefit loss of debt management and agency costs that is characterizes as expropriation. For example, when deciding the extent to which the company need to avoid tax, managers should take political cost if they were to be found out by the IRS (Hanlon and Slemrod, 2009). The net income of corporate tax avoidance depends on the balance and trade-off of the advantages and disadvantages. In view of this , we propose the following three competing hypotheses:
l Proposition H1a: The higher the company’s tax avoidance level is, the lower the cost of debt financing that company faces;
l Proposition H1b: The higher the company’s tax avoidance level is, the higher debt financing costs that company faces;
l Proposition H1c: there is no statistically significant correlation between corporate tax avoidance level and debt financing costs.
Recent literatures have begun to introduce agency theory into tax avoidance research and studies. In modern companies, especially those who have separation between management and ownership, investors preferring neutral risks expect managers to work hard to maximize the shareholders’ interests, including the pursuit of minimization corporate tax under the condition that marginal profit is greater than the marginal cost. Slemrod (2004), Chen and Chu (2005), Croker and Slemrod (2005) all analyze corporate tax avoidance activities under the theory structure of agency theory. Among them, Chen and Chu (2005) use a standard principal – agent model to analyze the efficiency loss brought by tax avoidance activities under the condition of separating ownership and management. From another perspective, Crocker and Slemord (2005) examine the impact putting on relative efficiency of company principles and agents by the corporate tax avoidance punishment and executive compensation contracts of those who decide the credits of pretax profit. So far, documents before these researches are all assume that there is no need to consider
agency issues when analyzing corporate tax avoidance.
Based on researches mentioned before, if tax avoidance activities are able to create profits for shareholders, and at the same time, equity incentive contracts of top management and executives can contribute to the interest coordination between managers and shareholders, those companies who avoid taxes mainly through using after-tax profit as incentive contracts should show higher level of tax avoidance. Philip (2003) assesses companies using after-tax profits as criteria to assess the performance of the company’s branch managers, and he finds lower effective tax rates of these companies. However, Desai et. al (2007) analyzed the impact shaded on tax avoidance by equity incentive contracts of top management and corporate governance, finding that between equity ownership incentives and tax avoidance, there do exist significant negative correlation, and the negative correlation is especially obvious in companies having worse corporate governance. Their theoretical analysis reveals that, if the corporate tax avoidance erosions the companies’ interests in the name of complex tax avoidance transactions, then strengthening executive equity ownership incentives can be a better way to coordinate the agency conflicts between agents and principles, and ultimately achieve the goal of weakening the corporate tax avoidance level. That is to say, if top managements are appropriately incented by the principles, corporate tax avoidance itself is the byproduct of the pursuit of shareholders’ interest maximization. Desai and Dharmapala (2009) state in the research that, there is no significant correlation between corporate tax and corporate value. However, in those companies with institutional ownerships, corporate tax avoidance level is significantly correlated with value of the company (Gompers et al. 2003). This evidence proves that whether tax avoidance can help with company value improvement depends on whether shareholders can effectively control the agency problems inside the company. Moreover, behind the tax avoidance there is not only agency costs inside the company, but also corruptions between top management and government officials. There is bribery business between corporate managers and government officials hidden in the process of tax avoidance (Armstrong et al. 2012; Slemrod 2004). These research
indicate that, inside the corporate tax avoidance activities, there are agency costs that may erosion the shareholders’ interests, and better internal control can play an important role in reducing the agency costs taken by tax avoidance. Furthermore, investors are able to properly anticipate the potential profits, costs and risks taken by tax avoidance, and these factors can be reflected in the market value of the company.
The separation of ownership and management indicates that, if we want tax avoidance to be a meaningful activity, the owners of the corporate should design appropriate incentive and compensation system to ensure the tax decision of the company contribute to the after-tax profits for shareholders, in other words, profit of tax avoidance should larger than the cost of tax avoidance. Desai et. al (2007) through theoretical analysis point out that self-interested managers perhaps occupies the value and interests of company through the process of designing complex tax avoidance and trading activities. In this case, strong external tax audit can play a governance role, just like that of monitors. The goal of tax authorities and external investors are similar, so that they are able to deal with the possible and potential internal embezzlement of interest in joint efforts. The researchers indicate that, tax oversight performs a function of external governance (Desai et. al, 2007). In countries that having higher tax rate but weaker tax governance, corporate value and shareholders interest are suffering more tax avoidance level and inside rampant encroachment (Desai et. al, 2007). In 2000, after Putin came to power, tax inspection and audit has been tightened, and as a result, not only the government’s tax revenue has increased significantly, but also the related transactions get curbed. Although the governmental tax authorities do not care the agency cost inside the company, but from an objective perspective, tax audit and inspection contribute to reducing the agency costs to a large degree. In the expectation theoretical model of Desai et. al (2007), in corporates with worse corporate governance and internal control, with the increase of tax audit and tax inspection, the market value of the company will increase. This can be the evidence to prove that external inspection and oversight plays a similar regulate role on governance of the company, and especially in companies with worse internal control
and corporate governance, the tax audit function can be more obvious. From the evidence of Jeffrey et. al (2012), there is proof that in U.S. public firms, the firms tend to undertake less aggressive tax positions when tax enforcement is stricter. As I did some review on Chinese literature about tax inspection, although there is little related literature focusing on the similar function between corporate governance and tax audit, Hanlon and Heitzman (2010) has found that from different perspectives, the endeavor of government on tax has inhibition function on tax avoidance. Combined with theoretical analysis mentioned above, this thesis comes up with proposition H2: l Proposition H2: the facilitating (inhabiting) impact of tax audit putting on the
negative (positive) relation with debt financing cost is especially happens in companies with worse corporate governance.
III. Research Methodology
3.1 Data Source and Sample Selection
This paper will adopt archival empirical research. The research selects all A-share listed companies in America, and at the same time, whose headquarter should also be located in America as samples from 2008 to 2012. This does not include the following features of the sample: (1) the financial industry listed companies, (2) companies without information in income tax rates, (3) companies whose actual income tax rates are larger than 1 and (4) companies with net assets below 0, (5) companies without the relevant control variables. From a selection from 61244 items, finally I get 5188 company-year items. In order to control abnormal values, the continuous variable in the regression model are dealt with extreme value censored (WINSORIZE). Tax audit level refers to the audit probability of Internal Revenue Service (IRS) monitoring, and the audit probability data are gather from the Data Book from the IRS, as the instruction of Jeffrey et.al (2012). The debt costs total, nominal income tax data and
other data are searched from Compustat. The data processing is conducted by STATA 12.0 software.
3.2 Research Design
This paper adopts the corresponding regression model to study how company tax avoidance affects the company's debt financing costs. The dependent variable is the cost of debt financing, here after appropriate adjustments adopting from Jiang Yan (2009), the cost of debt financing is defined as the arithmetic mean of current interest cost and balances of interest liabilities in the beginning and ending balances. Explanatory variables are for the extent of tax avoidance, and here adopt four calculation methods to measure the company's effective actual tax rate.
Including Chen et al. (2010), many literatures have adopt many proxies that measure the effective tax rate or reflect the tax avoidance level, for example, the book-tax difference (BTD), BTD after excluding earnings management and effective cash tax rate and so on. However, I think, there is still many limitation to use these proxies to measure. For example, BTD reflects the difference between accounting profits and taxable income. Generally, it is perceived that the higher the proxy is, the higher the tax avoidance level company has (Mills, 1998). However, in fact, is it because the large accounting profits, or because the taxable income is small? Moreover, BTD has included the difference of policies, while the tax policy has been adjusted; it is hard for me to measure (Dai et al. 2006). So there can be limitations of BTD to measure the tax avoidance level. Another proxy should be effective tax rate, which mainly use the income tax, which are paid by cash divided by taxable income in the United States. However, there may exist some of the discount and manipulation such as using debt to credit and so on. So it is not a clever choice to measure tax avoidance level only use one kind of proxy to measure the tax avoidance level. To be detailed, many firms choose to register their new companies in “free trade zone” and countries or areas
with lower income taxes. Even further, many companies may move the whole company to those places. These are typical way of non-debt tax avoidance. As a result, this paper would like to take the measurement from Wu et al. (2010), we first test 4 ways of the tax avoidance level, if the value of the measurement is similar, then we can go on to test other variables, and this will increase the research robust to some degree.
Taking other characters and factors that may have impact on companies into consideration, modified from Kim (2011), this paper also controls other variables such as total asset, the growth of company, the share owned by the biggest shareholder, and other variables reflecting financial characters and equity structures of the company. This paper expects that the better performance of company with bigger size and longer listing time, the lower the debt financing cost of the company. On the other hand, companies with higher growth rate and higher debt rate, because of the high financial risks, they may suffer higher debt financing cost. While, as the variable testing equity ownership structure, the equity ownership rate of the biggest shareholder is not a clear variable for me to expect. Because equity of many companies are highly centralized in one or several big shareholders, for example, family-owned, etc (Anderson et al. 2003; Boubakri and Ghouma, 2010). If the big shareholders were able to manage the top management effectively and efficiently, then the agency costs would be reduced. Moreover, the biggest shareholder has higher authorization of cash flow, which may help to ensure and raise the debt holders’ confidence and invests. These reasons are all able to help lower the debt financing costs. However, apart from those, if big shareholders only pursue their own interest to control the company, and more specifically occupy the debtholders’ interests, then the debt financing cost will increase. Due to the uncertainty and trade-off, here I will retain my expectation on the relationship between biggest shareholder and cost of debt.
Regression model (1) aims to examine relationship between the tax avoidance level of the company and the cost of debt, especially how tax avoidance affect the cost of debt, by focusing on the coefficient of ETR a1. The lower the effective tax rate (ETR) is, the
higher level of tax avoidance the company has. Here, for the purpose of understanding the meaning of this coefficient, I make the coefficient multiplied by (-1). The detailed definition can be seen in table 1, the definition table of variables. After the adjustment, the bigger this coefficient is, the higher level of tax avoidance the company has. According to the statement of literature in this paper, here I expect that the higher level the corporate has, the lower level the cost of debt is. Thus, I expect that the coefficient a1 to be negative.
CODit = CODit =α0 +α1CASH ETRit +α2ROAit +α3LEVit +α4SIZEit + α5AGEit
+α6PPEt +α7GROWit +α8FIRSTit +YEAR_DUM + INDUSTRY_DUM+ηit (1)
Based on Dyreng et al. (2010), companies should take the IRS audits into consideration when deciding to what extent the effective cash rate changes when they want to avoid tax. According to Jeffrey (2012), audit probability is the proxy of level of IRS audit, symbolizing the probability of the company can be audited this year. The higher the AUDIT PROBABILITY, the higher level of IRS audits this year. AUDIT PROBABILITY is calculated as the number of face-to-face corporate audits completed in IRS fiscal year t in a given IRS asset size divided by total number of 1120 returns filed in calendar year t-1, in an IRS asset size (Jeffrey et al, 2012). At the same time, according to Desai et. al (2010), I divide the companies into two groups, in accordance with the median level of shareholders’ ownership rate. If the institutional investor’s ownership rate is higher than the median level, then the proxy is assigned with 1, and this group is defined as companies having high level of corporate governance; on the contrary, if the institutional investor’s ownership rate is lower than the median level, then the proxy would be assigned with 0, and the group is defined as companies having low level of corporate governance and internal control. The reason why this paper adopt the share owned by biggest shareholder is:
1. The research did by Desai et. al in 2009 adopts the share owned by institutional investors as the proxy of corporate governance quality. And my paper aims to test and verify the expectation in Desai et. al (2009), which has proposed a theoretical model testing relationship inside corporate governance, IRS audits and agency costs, and has made an expectation.
2. No matter whether institutional investors perform a governance function or not, compared with individual investors, institutional investors are more like sophisticated investors (Shleifer and Vishny, 1986; Chung et al., 2002; Hartzell and Starks, 2003; Bhojraj and Sengupta, 2003; Desai and Dharmapala, 2009). 3. . In most cases, companies that they are more interested and shigekura holdings
are perceived good quality. And there are many literatures using institutional investors as the proxy of corporate governance and internal control. Based on these reasons, it is reasonable to perceive that companies owning high level of institutional investors are companies with high internal control quality.
4. Other proxies that are used to examine corporate governance quality are contradictive. For example, proportion of independent directors. Many literature states that independent directors are not in function in many cases, whether they can perform a function of corporate governance is depends on their professional background and other factors (Carey et al., 1993). Furthermore, take external auditor reputation as example, higher level of external audit quality are associated with higher-level real earnings management, which will harm the growth of the company to a large degree (Chi Lisic, 2011; Lennox et al., 2010)
Moreover, about the proxies of separation of management control and cash flow control, there is a limitation to apply the degree of separation of the power. There is no clear objective boundary for us to know, to what degree do the separation may on behalf of good corporate governance quality. Moreover, this paper aims to examine many kinds of companies, including those family-owned, which may have lower level of separation of power (Anderson et al. 2003). Obviously, it is not wise to use the proxy of rights separation to examine companies with different property nature.
Taking into all difficulties to measure the corporate governance quality, it is reasonable to make a reference from Desai et. al (2009) use the share rate of institutional investors to examine the corporate governance quality. For readers to understand much easier, in this paper I will focus on comparing the different corporate governance level, how the coefficient of cross variable ETR*TM different. Here I expect the coefficient to be negative, and especially, be significant in the group with lower level of corporate governance. Definition of main variables can be seen in Table 1.
CODit =θ0 +θ1ETRit +θ2ETRit*Audit Probabilityit +θ3Audit Probabilityit +θ4ROAit + θ5LEVit +θ6SIZEit +θ7 PPEit +θ8 SHARE_OWNEDit +YEAR_DUM +INDUSTRY_DUM +Ψit (2)
Table 1 Definition of Main Variables Variable
Attributes
Variable Name Variable Definition
The dependent variable
The actual cost of debt financing（COD）
COD=the current interest / {(Closing balance of interest-bearing debt + Beginning balance of interest-bearing debt)/2} Explanatory variables Company tax avoidance level (ETR)
Effect tax rate 1 (ETR1)
(-1)*(income tax / After taxable profit adjusted accounting income)
Effect tax rate 2 (ETR2)
(-1)*(income tax) / (After taxable profit adjusted accounting income – deferred tax)/ Nominal income tax rate
Effect tax rate 3 (ETR3)
(-1)*(income tax-deferred tax)/ After taxable profit adjusted accounting income-deferred tax)/ Nominal income tax rate
Effect tax rate 4 (ETR4)
(-1)*(income tax-deferred tax)/ After taxable profit adjusted accounting income
IRS audit
the number of corporate tax return audits completed in the IRS’s fiscal year t for an
level (Audit Probability)
Audit Probability IRS asset size group a, divided by the number of corporate tax returns received in the previous calendar year for the same IRS asset size group a.
Control Variables
Return on Asset (ROA) Net income/total assets
Asset-liability ratio (LEV) Ending total liabilities/total assets The Company Size (SIZE) The natural logarithm of total assets The PPE Proportion (PPT) PPE end of year/ total assets
The Growth of Company (GROW)
Income growth rate
Centralization of shares (SHARE OWNED)
Share owned by the biggest shareholder
Industry of the Company (INDUSTRY)
Dummy variables of different industries
Time (YEAR)
Dummy variable 0~1 during year
2008~2012
This table displays the definition of variables used later in regression models.
IV. Empirical Results analysis
4.1 Description Statistic Analysis
Table 2 provides the description statistics analysis about the sample of this paper. In the table, we can see that the media value and mean value of the real cost of debt financing are 6% and 5.9%, and the maximum of the year’s debt financing cost is 11%. However, the real loan rate of the year may still be underestimated. It has been proved that the monopolization of banking industry and tax policies provide platform for managers and some governmental officials to take bribes or real earnings management, which is able to harm the income of the companies (Martucci 2001; Hollingsworth 2002; Robinson et al. 2010). ETR1, ETR2, ETR3 and ETR4 are effect
tax rate that I adopt different ways to measure. We can see from the table that no matter which way I choose to calculate, the effective tax rates can be around 23%. During 2008 and 2012, the nominal income tax rates in American companies are around 33%. Taking different areas, industry and local tax policies, the effective tax rate can be reasonable.
Table 2 Description Statistics
Variable Obs Mean Medium Min Max Std. Dev
COD 5188 0.060 0.059 0 0.110 0.03 ETR1 5188 0.232 0.232 -0.157 0.703 0.178 ETR2 5188 0.229 0.232 -0.139 0.667 0.182 ETR3 ETR4 5188 5188 0.233 0.235 0.225 0.228 -0.187 -0.575 0.994 0.989 0.212 0.269 ROA 5188 0.043 0.038 -0.018 0.182 0.03 LEV 5188 0.479 0.510 0.078 0.978 0.169 SIZE 5188 7.771 7.765 5.129 10.992 0.957 PPE 5188 0.409 0.392 0.000 1.391 0.195 GROW 5188 0.192 0.162 -0.721 2.589 0.430 SHAREDOWNED 5188 0.351 0.343 0.000 0.749 0.208
This table displays the description data of variables used later in regression models. The COD is modified from Desai et al. (2007), which is calculated as the real cost of debt. ETR1, ETR2, ETR3 and ETR4 are effective tax rates to measure the level of tax avoidant. For the reason of robust, I choose 4 ways to calculate the ETR, and compare the medium value, mean value etc. to evaluate the tax avoidance level and reasonability of the proxy. ROA is the return on asset. LEV is the asset -liability ratio. Size is the total asset of the corporate. PPE and SIZE are the natural logarithm of the PPE and total assets. GROW is the growth rate of the firm’s income. And SHAREOWNED is the proportion of share owned by the biggest shareholder.
Note: the numbers inside brackets are t-statistics adjusted with heteroscedasticity by White (1980); *p,0.1, **p<0.05, ***p<0.01; coefficients of all variables are dealt with rounding, and reserved until after three decimal places.
4.2 Multiple Regression Analysis
To test and verify the hypothesis this paper proposes rigorously and in-depth, I will use the empirical models that are proposed by former literatures to examine the impact that corporate tax avoidance has on cost of debt. For the purpose of robust,
here I use 4 ways to measure the level of tax avoidance. As stated before, this paper expects that the proxies of tax avoidance level ETR should all be negatively significant. In other words, the more the firm tends to avoid tax, the lower the cost of debt will be. Table 3 displays and explains corresponding results, the regression coefficient of ETR1, ETR2, ETR3 and ETR4 are -0.006, -0.006, -0.005 and -0.004, and they all pass the statistical significant test at 1% level. This means, every time the corporate tax avoidance level increase 1%, correspondingly, the cost of debt will decrease 0.4%~0.6%. This indicate that the higher level of tax avoidance a firm has, the lower the demand for this firm to avoid tax through debt. This can help reasonably explain that firms are tend to choose to transfer their firm to areas which has lower tax rates, make transactions with related parties and other non-debt form to avoid taxes, and thus reducing the agency costs which brought by tax avoidance through debt. Moreover, the increase of the cash flow brought by tax avoidance will contribute to the increase of firm’s solvency and reduce the default risk and even bankruptcy risk (Petersen and Rajan, 1994). As a result, debtholders will take this information from companies who avoid taxes successfully into the decisions of credit pricing.
Table 3 Tax Avoidance and Cost of Debt
Variables (1) (2) (3) (4) Expected sign
Dependent variables: COD=cost of debt
ETR1 -0.006*** (-) (-4.558) ETR2 -0.006*** (-) (-3.678) ETR3 -0.005*** (-) (-4.392) ETR4 -0.004*** (-) (-4.253) ROA -0.088*** -0.088*** -0.088*** -0.079*** (-) (-11.428) (-11.379) (-11.417) (-11.282) LEV 0.018*** 0.018*** 0.018*** 0.018*** (+) (13.028) (13.028) (13.042) (13.106) SIZE -0.001** -0.001** -0.001** -0.001** (-) (-2.049) (-2.178) (-2.159) (-2.118) PPE 0.009*** 0.009*** 0.009*** 0.009*** (?)
(10.221) (10.198) (10.191) (10.279) GROW -0.000 -0.000 -0.000 -0.000 (+) (-0.147) (-0.156) (-0.119) (-0.112) Share Owned -0.009*** -0.009*** -0.008*** -0.008*** (?) (-4.253) (-4.253) (-4.253) (-4.253) η 0.012*** 0.014*** 0.014*** 0.013*** (3.086) (2.955) (3.109) (3.047) Year and Industry
Controlled Controlled Controlled Controlled
F-value 43.539 43.287 43.489 43.637
Adj.R2 0.181 0.180 0.179 0.179
N 5188 5188 5188 5188
Note: Standard errors in parentheses * p < 0.1, ** p < 0.05, *** p < 0.01
This table displays the description data of variables used later in regression models. The COD is modified from Desai et al. (2007), which is calculated as the real cost of debt. ETR1, ETR2, ETR3 and ETR4 are effective tax rates to measure the level of tax avoidant. For the reason of robust, I choose 4 ways to calculate the ETR, and compare the medium value, mean value etc. to evaluate the tax avoidance level and reasonability of the proxy. ROA is the return on asset. LEV is the asset -liability ratio. Size is the total asset of the corporate. PPE and SIZE are the natural logarithm of the PPE and total assets. GROW is the growth rate of the firm’s income. And SHAREOWNED is the proportion of share owned by the biggest shareholder. AUDIT PROBABILITY is the firms that are actually audited by the IRS in year t devided by the total number of 1120 returns field in calendar year t-1, in an IRS asset size Jeffrey et.al (2012).
Note: the numbers inside brackets are t-statistics adjusted with heteroscedasticity by White (1980); *p,0.1, **p<0.05, ***p<0.01; coefficients of all variables are dealt with rounding, and reserved until after three decimal places. Tax audit level refers to the audit probability of Internal Revenue Service (IRS) monitoring, and the audit probability data are gather from the Data Book from the IRS, as the instruction of Jeffrey et.al (2012).
Further, the theoretical analysis of Desai et.al (2007) indicates that, managers that are intend to maximize their own interests and controlling shareholders are occupying company’s interests through designing complicated transactions and activities for the company to avoid tax and at the same time, satisfy their private interests. They point out that under this circumstance, powerful tax audits by government will perform a function of monitoring management Desai et.al (2007). In this case, the aim of tax authorities and external investors are converge, so they are able to incur insiders’ occupation activities of interests. If so, the benefits brought by tax avoidance are very likely to be deducted by the agency costs. According to the expectation of Desai et.al
(2007), given that tax audits has similar function of external corporate governance, in next analysis, coefficient of tax audits should be significant since the audit probability is rising during 2008 and 2012.
In Desai et.al (2009), it is found that there is no significant relationship between tax avoidance and firms’ market value. In the research, it is stated that in companies of institutional ownership, tax avoidance are positively related to corporates’ market value Desai et.al (2009). They repute that whether tax avoidance activities are able to increase the firm’s market value is depend on whether shareholders are capable of controlling agency costs existing inside the companies. Because of lacking in a widely recognized proxy to measure the corporate governance level, this paper is going to adopt a proxy that is already examined. That is, the rate of share owned by institutional investors. According to the description data, I divide the sample into two groups. One is comprised of companies with companies with institutional investors whose ownership rate is higher than the medium level, and the other one is comprised of companies with institutional investors whose ownership rate is lower than the medium level, on behalf of higher corporate governance quality and lower corporate governance quality respectively. Table 4 reports the related results and analysis. In the analysis, I will put emphasis on the cross coefficient of ETR*Audit Probability and on the difference of the cross coefficient in companies with different corporate governance level.
Take column (1) and column (2) in Table 4 for example, in the group comprised of companies with lower rate of institutional investors’ ownership, the coefficient of ETR*Audit Probability is -0.001, and is significantly positive on statistical level of 5%; in group comprised of companies with higher rate of institutional investors’ ownership, the coefficient of ETR*Audit Probability is -0.001, and is not significantly on statistical level of 5%. That is to say, in sample that is comprised of companies with lower rate of institutional investors’ ownership, the corporate governance functions performed by IRS audits can obviously strengthen the negative relationship
between tax avoidance and debt financing cost; however, in sample that is comprised of companies with higher rate of institutional investors’ ownership, the corporate governance functions performed by IRS audits can slightly strengthen the negative relationship between tax avoidance and debt financing cost. This result proves the theoretical expectation of Desai et. al (2007), which is, in firms having lower corporate governance and internal control quality, with the increase of IRS audit, market value brought by tax avoidance activities will increase more. Other columns are results and analysis got through analysis of control variables and other way to measure the corporate governance and tax avoidance level. As we can see, there are same results and conclusions. However, the sign of GROW is opposite to that I expected, it is not important since it is not significantly affect the COD. Same explanation can be applied to the sign of ETR2 in higher institutional ownership group. Despite SIZE and GROW, other coefficients are all significantly affect the COD, so it is reasonable and successful to set these control variables. The research analysis of Table 4 proves that, IRS audit plays a substitute function with other management control system, and this function is especially significant and important in companies having lower quality of corporate governance and internal control. This conclusion is consistent with the proposition H2.
Moreover, when looking at the control variables in Table 3 and Table 4, we can find that for companies with better income growth rates, larger total assets and higher proportion of ownership taken by institutional investors, the costs of debt of these companies are tend to be much lower. On the other hand, in companies with larger debt proportions, the costs of debt would be relatively high, and this is probably because of the potential financial risks. These are all consistent with the analysis and expectation of this paper and reference literatures.
Variables (1) High I (2) Low I (3) High I (4) Low I (5) High I (6) Low I (7) High I (8) Low I Expected sign Dependent variables: COD=cost of debt
ETR1 -0.001 0.000 (+/-) (-1.258) (1.568) ETR1*Audit Probability -0.001 -0.001** (-) (-1.182) (-2.078) ETR2 -0.000 0.000 (+/-) (-0.525) (0.031) ETR2*Audit Probability -0.001 -0.002** (-) (-1.452) (-1.965) ETR3 0.000 -0.000 (+/-) (0.546) (-0.915) ETR3*Audit Probability -0.001 -0.002** (-) (-1.588) (-2.108) ETR4 0.000 -0.000 (+/-) (1.547) (-0.416) ETR4*Audit Probability -0.001 -0.003* (-) (-1.607) (-1.934) Audit Probability 0.001* 0.001 0.001* 0.001 0.001** 0.001 0.001** 0.000 (1.677) (1.485) (10768) (1.458) (2.105) (1.228) (2.014) (1.129) ROA -0.056*** -0.094*** -0.056*** -0.094*** -0.056*** -0.094*** -0.056*** -0.094*** (-) (-6.847) (-9.038) (-6.869) (-9.038) (-6.905) (-5.989) (-7.127) (-8.976)
LEV 0.018*** 0.021*** 0.018*** 0.022*** 0.018*** 0.022*** 0.018*** 0.021*** (+) (7.656) (10.523) (7.755) (10.547) (7.818) (10.556) (8.428) (10.545) SIZE -0.000 -0.001*** 0.000 -0.001*** -0.000 -0.001*** 0.000 -0.001*** (-) (0.333) (-3.959) (0.333) (-3.959) (0.338) (-3.987) (0.333) (-3.958) PPE 0.007*** 0.008*** 0.007*** 0.008*** 0.007*** 0.008*** 0.007*** 0.008*** (+) (-4.757) (-4.028) (-4.762) (-4.187) (-4.734) (-4.118) (-4.982) (-4.185) GROW -0.000 -0.000 -0.000 -0.000 -0.000 -0.000 -0.000 -0.000 (+) (-0.011) (-0.032) (-0.012) (-0.122) (-0.008) (-0.022) (-0.010) (-0.022) Share Owned -0.009*** -0.008*** -0.008*** -0.008*** -0.009*** -0.008*** -0.010*** -0.008*** (+/-) (-4.655) (-4.103) (-4.644) (4.104) (-4.655) (-4.102) (-4.667) (4.107) Ψ 0.023*** 0.044*** 0.023*** 0.044*** 0.023*** 0.044*** 0.023*** 0.044*** (5.077) (4.222) (5.082) (4.199) (5.071) (4.223) (4.775) (4.022) Year and Industry
Controlled Controlled Controlled Controlled Controlled Controlled Controlled Controlled Year and
Industry
Controlled Controlled Controlled Controlled Controlled Controlled Controlled Controlled
F-value 18.762 23.667 18.556 23.657 18.708 23.567 17.677 23.645
P-value 0.163 0.186 0.164 0.186 0.167 0.197 0.161 0.189
Adj.R2 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
N 2594 2594 2594 2594 2594 2594 2594 2594
Note: Standard errors in parentheses * p < 0.1, ** p < 0.05, *** p < 0.01
This table displays the description data of variables used later in regression models. The COD is modified from Desai et al. (2007), which is calculated as the real cost of debt. ETR1, ETR2, ETR3 and ETR4 are effective tax rates to measure the level of tax avoidant. For the reason of robust, I choose 4 ways to calculate the ETR, and compare the medium value, mean value etc. to evaluate the tax avoidance level and reasonability of the proxy. ROA is the return on asset. LEV is the asset -liability ratio. Size is the total asset of the corporate. PPE and SIZE are the natural logarithm of
the PPE and total assets. GROW is the growth rate of the firm’s income. And SHAREOWNED is the proportion of share owned by the biggest shareholder. AUDIT PROBABILITY is the firms that are actually audited by the IRS in year t devided by the total number of 1120 returns field in calendar year t-1, in an IRS asset size Jeffrey et.al (2012).
Note: the numbers inside brackets are t-statistics adjusted with heteroscedasticity by White (1980); *p,0.1, **p<0.05, ***p<0.01; coefficients of all variables are dealt with rounding, and reserved until after three decimal places. Tax audit level refers to the audit probability of Internal Revenue Service (IRS) monitoring, and the audit probability data are gather from the Data Book from the IRS, as the instruction of Jeffrey et.al (2012). Moreover, because of the sample is divided into two groups according to the medium value, the total number tested in each group is 2594.
V. Conclusion and Limitation
Before writing the paper, the author is interested with many questions. For example, whether tax avoidance can increase the shareholders’ interests? Whether IRS audits implemented by IRS perform external monitor and governance function (i.e., Crocker and Slemrod 2005; Shackelford et al. 2008)? What is the relationship between external tax audits implemented by tax authorities and government and other corporate governance systems and mechanisms? This is an research field new in American academic research. Through searching data both systematically and by hand, this paper use a proxy proved by former literatures to evaluate the impact that tax avoidance has on cost of debt. Through research and study, the higher tax avoidance level is, the less level of company dependent on debt financing, and the company is able to have higher level of cash flow to deduct and clear the debt, then the lower the debt default risk and bankruptcy risk will be, and ultimately and consequently, the lower the cost of debt is.
Behind the tax avoidance, there exists agency costs inside the company. Insiders would occupy external shareholders’ interests and maximize their own interests through complex and complicated tax planning techniques. The economic consequences of tax avoidance should be the comprehensive result after trade-off between the benefits and costs of tax avoidance. Different from external monitoring, internal control and corporate governance of company is the mechanical insurance of
incurring interests conflicts inside shareholders, controlling shareholders and small shareholders. In that way, how do external tax inspection and tax audits act in evading the disadvantages of tax avoidance activities? Referring to former literatures, I adopt the rate of share owned by institutional investors to measure the corporate governance quality. Through analysis, I find that the management function of IRS audits is especially obvious in companies with lower rate of share owned by institutional investors. This finding further proves and explains the relationship between tax avoidance and corporate governance, and makes it clear that in the process of corporate governance and internal control, IRS audits play a substitute function of corporate governance. This result further tests and verifies the theoretical expectation of Desai et. al (2007).
The theoretical indication of this paper’s results of this paper can be seen from two perspectives. From the view of practice and reality, the results provides access for corporate shareholders to better understand the duality including benefits and costs of tax avoidance, instructing debtholders better verify the real content behind tax avoidance activities of firms. This can be concluded as the instructive implication of this paper. From the view of theories, this paper provides the preliminary economic consequences for companies in America. Although the aim of IRS audit may not be improve the internal control and corporate governance of companies, the results of this paper do imply and indicate that, IRS audits do act similar function for firms during the process of incurring illegal tax avoidance and consolidate tax orders of companies, answering the questions proposed by Cowell (2004) and Kopczuk and Slemrod (2006). In such a way, research and findings of this paper develop the literature and theory in respect of corporate finance and corporate governance, having theoretical meaning to some degree.
There are limitations of this paper. First of all, although the paper adopt four ways to measure the effective cash rate, however, because of the limitation of techniques, this paper do not take the econometrics theory of dual differential. If possible, further
research can adopt this theory to deeply verify the results. The reason is, if not, there may exist a problem of loss of control variables. The modification of model to test the interaction effect of IRS audits on the relationship between tax avoidance and cost of debt has referred to literatures from both America and China. Due to the lack of experience of the author, the proxy may be further evaluated. Moreover, there may exist different income taxes in different states and provinces. Because of the difficulty on searching data, this paper does not evaluate the tax avoidance level of different states (Frank et al. 2009). As a result, the result of this paper can be further proved and evaluated. And this can as well as be implication of future researches.
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Appendix:
Explanation of some contradicted questions:
1. Whether debt can act as a way of corporate governance differs depends on the situation of the located areas and nature of the company. For example, in family-owned companies, the effect of debt is limited, and the board significantly affects the operation of the company. On the other hands, take China as example, because of the affect of society and mechanism, companies’ operation are highly affected by external environment, e.g. new policies, relationship between governmental officers and top managements. Even worse, the effect of debt from formal financial source cannot be better than other informal financing measures, such as business credits.
2. Registering companies and opening bank accounts in free-trading zones and areas enjoys tax discount to operate is common in some modern companies. However, this kind of operations and businesses do not have clear business natural or purpose, which reflects that it is highly possible for agency costs generated by tax avoidance inside the companies.
3. A simple explanation of agency costs during tax avoidance: in a company having centralized ownership, controlling shareholder has 10% rights on cash flows, and the control rate is 30%. If the controlling shareholder or top management use the name of tax avoidance, stating that they would help each shareholder to save $1 of income tax. However, they are able to occupy the total $3 through complex and complicated tax avoidance activities, for example, transactions with related parties, transfer pricing and other real earnings management activities. And tax avoidance is only the shelter for them to maximize their own interests. Through calculation, the number that controlling shareholders occupy others’ interest through tax avoidance is $3.1(=1*10%+3), and their cost is only $0.3(=3*10%), net income is $2.8. However, all of the other shareholders bear a loss up to $1.8(=1*90%-3*90). The benefit of controlling shareholders and other
shareholders is still the tax payments $1 (=2.8-1.8), but the wealth is transferred from small shareholders to the controlling shareholders.
