BOARDS, INVESTOR PROTECTION AND ETHICS STRATEGY Masterthesis Master of Science Accountancy & Controlling University of Groningen, Faculty of Economics & Business August 31th, 2017 Hendrik T. de Boer BSc Student number: 2208911 e-mail: h.t.de.boer@student.rug.nl Supervisor | university | department of Accounting N. (Nazim) Hussain PhD Supervisor | corporate | PricewaterhouseCoopers | PwC L. (Linda) Arends MSc EMA
Abstract
The aim of this paper is to investigate if governance mechanisms are associated with ethics strategy, comprising corporate social responsibility performance and payment of tax by corporations. Based on stakeholder theory, all stakeholders are important for success of a corporation. Taking stakeholder interests into account in corporate strategy, is argued to function as a risk management mechanism that benefits shareholders. Based on agency theory, managers are expected to use information asymmetry to misappropriate funds reserved for other stakeholders. By investigating a large international sample of listed firms, this paper intends to defragment the discussion on CSR and tax avoidance. The results of this investigation indicate an asymmetric relation between governance mechanisms and the distinct components of ethics strategy. Board size, board independence and investor protection are found to be positively associated with corporate social responsibility. Countries with higher levels of investor protection enable boards to better use their higher independence and higher cumulative expertise and experience, to induce managers to perform better in CSR. Board size and investor protection are positively associated with effective corporate tax rates. Interestingly, the results indicate a substituting relation between board size and investor protection, in association with tax avoidance. Finally, practical implications for shareholders and governments are presented to use governance mechanisms to induce managers to implement corporate ethics strategy.
I. Introduction
Corporate social responsibility (CSR) is increasingly popular in today’s corporate practice. Large corporations dedicate significant budgets to CSR projects to act like ‘good citizens’ in society, by treating stakeholders in a fair way. While companies are actively looking after the interests of certain stakeholders through CSR projects, the controversy of large scale tax avoidance by multinational companies indicates that a number of these firms are actively minimizing their contribution to governments (Hodge, 2012; Jenkins & Newell, 2013). The paradox here is that corporate funds are used to facilitate CSR projects, benefitting stakeholders and strengthening the good reputation of the company. Meanwhile, companies are aiming to lower the corporate tax outlay, risking their good reputation due to controversially high levels of tax avoidance (Landry, Deslandes & Fortin, 2013).
In the past years, various transnational corporations were publicly criticized over their tax avoidance practices by journalists and civil society organizations (Hodge, 2012; Jenkins & Newell, 2013). Pressure is exerted by governments, for instance Brittan plans a worldwide ‘clampdown’ on tax aggressiveness (Faith, 2009: pp 4). Based on the leak of more than 11.5 million documents of the Panamanian law firm Mossack Fonseca in early 2016, multiple governments including Australia, Austria, Brazil, France and Sweden started investigations of ‘financial wrongdoing’ by corporations and individuals (MacSwan, 2016). Tax avoidance is a “major global issue” and is now “more firmly on the agenda than ever before.” (Jenkins & Newell, 2013: pp 392).
Tax avoidance has severe consequences and influences the lives of many people (International Tax Review, 2010). The ‘Enough Food for Everyone IF’ campaign states that tax avoidance is a cause of starvation in undeveloped countries (International Tax Review, 2013: pp 22). Consequences of tax aggressiveness are perceptible in the developed world as well. In order for a government to fulfill its duties, it requires sufficient tax income (Avi-Yonah, 2009). This to: facilitate education, healthcare, the military and various other affairs like paying pensions of public servants (Markey, 2014). Because the government is an important stakeholder for
as a stakeholder and taking tax avoidance into account as part of corporate strategy, deserves to be investigated. The controversy in international media and severe consequences for people, make integration of tax avoidance in corporate (ethics) strategy a relevant and interesting research topic.
Notable is the ‘under-sheltering puzzle’ (Weisbach, 2002). This phenomenon entails that a substantial amount of companies is avoiding less tax than legally possible, for a reason that is yet unknown. The ‘under-sheltering puzzle’ demonstrates that not all corporations implement extremely tax aggressive strategies. Similar to corporate social responsibility outlay, tax payments are a corporate disbursement benefitting stakeholders. Because sub-optimal tax avoidance is considered a “boundary condition for CSR” (Dowling, 2014: pp 173), there is a strong call for research that integrates CSR and tax avoidance (Chan, Mo & Tang, 2016; Dowling, 2014; Hanlon & Heitzman, 2010; Huseynov & Klamm, 2012; Jenkins & Newell, 2013). This paper aims to investigate CSR, explicitly in conjunction with tax avoidance, using the concept of ethics strategy. The concept of ethics strategy entails that corporations should focus on what society ‘values’ most (Frederick, 1986: pp 137). This value is expressed through the functioning of markets and corrective actions from governments. Governments have a crucial role in distributing means to stakeholders that are otherwise disregarded. To enable governments to fulfill this duty towards society, funds are required. Corporations that employ an ethics strategy will engage in CSR combined with limited tax aggressiveness, because, “tax payments can be considered a clear measure of the direct financial contribution a company makes” to the government (Dowling, 2014: pp 174). The concept of ethics strategy is used in this investigation, because it explicitly emphasizes the interests of society. By jointly investigating CSR and tax avoidance, the interest of the government is more explicitly accounted for in this investigation.
The aim of this paper is to investigate how governments and shareholders can induce corporate decision makers to implement ethics strategy, and if performance on the components of ethics strategy is affected symmetrically. To this end, the association between governance mechanisms and tax payment and the association between governance mechanisms and CSR are
national investor protection. This paper is intended to defragment the discussion on CSR and tax avoidance using an agency theory perspective in an international setting and to give recommendations to governments and shareholders of corporations to reduce severe tax aggressiveness.
Tax avoidance is defined as: “anything that reduces the firm’s cash effective tax rate over a long time period” (Dyreng et al., 2008: pp 62). In this paper, a period of five years is investigated. Specifically, corporate income tax is investigated, because avoidance of this tax is most controversial. The concepts tax avoidance and tax aggressiveness are used interchangeably when referring to the phenomenon. Tax avoidance is not illegal, but abiding to the letter of the law rather than the ‘spirit of the law’ (Dowling, 2014: pp 173 & 174). I define CSR as ‘performance in taking care of the interests of stakeholders on the pillars of economic-, environmental-, social- and corporate governance’. The concepts firm and corporation are used interchangeably when referring to a business organization. Because strategy is about goal realization, this paper uses a consequentialist standpoint. Consequentialism focusses on goal realization, rather than assessment of intentions. In ethics strategy, goal achievement is expressed by CSR performance and the effective corporate income tax rate of firms.
The remainder of the study is organized as follows. The “Theory and hypotheses” chapter discusses previous literature and presents the development of the research hypotheses. The “Research methods & data” chapter lays out the research design and presents the sample used. Research results are discussed in the fourth chapter. Finally, the “Conclusion and discussion” chapter concludes the outcomes of investigation and presents practical implications for
II. Theory and hypotheses
This section discusses literature on the association between governance mechanisms and the components of ethics strategy. First, the agency theory, stakeholder theory and the concept of corporate social responsibility are presented. Second, literature on the risk reducing functions of both components of ethics strategy are discussed. Third, managerial decision making on ethics strategy is discussed by taking an agency theory perspective, for the components of ethics strategy. This is followed by literature on governance mechanism in relation to ethics strategy. The following “hypothesis development” section, presents the research hypotheses.
2.1 Literature review
The agency theory addresses conflicts of interest between principals and agents (Jensen & Meckling, 1976). The principal hires an agent to perform a specific task. Because the agent performs this task, he has more specific knowledge of the task and context, resulting in information asymmetry between the agent and the principal. Unaligned goals and distinct risk tolerances incentivize managers to misuse this information asymmetry to extract private benefits.
The stakeholder theory argues that instead of solely focusing on the interest of stockholders, firms should consider the interest of other individuals and groups (Freeman, 1988). These groups are considered a stakeholder if they affect, or are affected by the corporation. Examples of stakeholders include: employees, customers, suppliers, creditors, communities, trade unions, governments and investors. The stakeholder theory posits that corporations should manage stakeholders by taking the interests of these groups into account in corporate decision making. By choosing this approach, corporations will improve their ability to create value through creation of competitive advantages (Freeman, 1988; Jones, 1995).
An earlier concept that regards the role of a firm in society is Corporate Social Responsibility (CSR). This role entails taking responsibility to act as a ‘good corporate citizen.’ This can be achieved by complying to laws, doing social good and acting in accordance with ethical
production processes, selecting suppliers that avoid the use of child labor, and organizing projects to help the poor in less-developed countries.” (Liang & Renneboog, 2017: pp 853). By refraining from controversial strategies, corporations are not exposed to the risk of public discovery. Ethics strategy reduces the risk of negative publicity on tax aggressive strategies. The reputation of a company is ‘an invaluable asset’, that may be damaged by disclosure of tax avoidance (Landry et al., 2013: pp 611). Customers and suppliers will stop doing business with controversial firms. Public discovery of tax avoidance results in lower profits and cash flows which leads to falling stock prices for these corporations (Hanlon & Slemrod, 2009). The chance of discovery increases if a corporation is more tax aggressive, resulting in higher ‘stock price crash risk’ for firms engaging in high levels of tax avoidance (Kim et al., 2011). By paying more taxes, corporations do not face the risks related to controversially high levels of tax avoidance. CSR has a substantial benefit for corporations by reducing risk (Harjoto & Jo, 2015). This is a result of the ‘social capital’ CSR intensive firms build with stakeholders (Zahller et al., 2015). Superior CSR disclosure promotes the perception of organizational legitimacy. Customers value the CSR efforts and reward firms by remaining loyal (Cheung, 2016). This results in ‘social resilience’ to endure future ‘exogenous shocks’ to firms (Zahller et al., 2015: pp 155). By implementing ethics strategy, corporations reduce risks and are able to build relations with customers that will remain loyal.
Based on stakeholder theory, all stakeholders are important for the success of a corporation. By taking the interests of stakeholders into account in corporate strategy, risk is reduced. This incentivizes shareholders to have ethics strategy implemented. Managers that make strategic decisions in a firm, have different incentives than stockholders. Based on agency theory, managers use the information asymmetry between themselves and shareholders to make strategic decisions in their private interest. Through private rent extraction managers misappropriate corporate funds that are reserved for other stakeholders. These private interests affect decisions on both components of ethics strategy.
Corporate tax aggressiveness is substantially influenced by managers (Dyreng et al., 2010). Decisions of these managers are heavily shaped by their personal ‘values and views’ (Guth & Tagiuri, 1965: pp 123). Two conflicting views are presented: the stockholder view and the stakeholder view. The stockholder view focusses on the interests of owners of the firm, whereas the stakeholder view emphasizes also taking into account interests of other stakeholders. Managers justify controversially low contributions to the government, by embracing the stockholder view (Sharer & Simmons, 2008). This results in focus on short term stock price increases and disregards the interests of other stakeholders. The decisions of managers are not solely determined by personal values and views, because incentives impact their choices. Empire building, compensation contracts and career concerns incentivize managers to engage in earnings management and consequently affect the tax position of a company (Ball, 2009; Kothari et al., 2009; Kim et al., 2011). These incentives motivate managers to engage in non-transparent and highly complex tax schemes to minimize effective taxes (Taylor & Richardson, 2012). The lack of transparency of operations and income, caused by transactions related to tax avoidance equip managers with “means, masks and justifications” for opportunistic behavior (Desai & Dharmapala, 2006; Kim et al., 2011: pp 641). Impact of the stockholder view of managers is not limited to tax aggressiveness. Managers with this view are reluctant to invest in the relations with stakeholders. The stockholder view results in corporate strategies aimed at short term profits and stock price increases. To increase short term profits and value, managers will not invest in CSR projects that are in the interest of other stakeholders. Based on agency theory, corporate funds will be used for opportunistic behavior of managers.
Corporations employ governance mechanisms to limit the opportunities for opportunistic behavior by managers. Key for these mechanisms is the separation between decision management and decision control (Fama & Jensen, 1983). In practice, executive managers are often controlled by non-executive managers to protect the interests of stockholders (Fama,
1980). These directors are specifically installed and responsible for this task and therefore the main governance mechanism under investigation. This paper aims to test whether board size and independence are positively associated with CSR and tax avoidance. In the international context, the level of investor protection is investigated in association with ethics strategy. 2.2 Hypothesis development Shareholders of a corporation control managers by employing governance mechanisms. One of these mechanisms is monitoring by non-executive directors of the board. Non-executive directors have an important function in advising and criticizing corporate strategy. These directors monitor executive managers and have the power to remove managers if necessary. Other responsibilities include assuring that appropriate financial controls and risk management are in place in the organization. Shareholders rely on the non-executive directors to monitor managerial decision making. According to stakeholder theory, incorporating interests of stakeholders in strategic decision making is crucial for success of a firm. As a result, non-executive directors are key in implementation of ethics strategy, consisting of high CSR performance and paying high effective tax rates. The level of ethics strategy therefore dependends of the effectiveness of non-executive directors. This effectiveness is argued to be influenced by the size of the board and the level of independence of the board. The number of directors on the board influences the effectiveness of monitoring. Larger boards have more expertise and experience, resulting in better advice and monitoring on managerial decision making (Dalton et al., 1999; Hillman & Dalziel, 2003). Individual directors are less restrained by high workloads, leading to increased effectiveness in larger boards (John & Senbet, 1998). Larger boards are better equipped to monitor and control opportunistic managers, resulting in implementation of ethics strategy. Board size is therefore positively related to ethics strategy, consisting of high CSR performance and paying high effective tax rates. Hypothesis 1: Board size is positively associated with ethics strategy.
Board effectiveness in managerial monitoring is not determined by the number of directors alone. Higher effectiveness is achieved by installment of independent outside directors. These directors have no history or other links in the firm, resulting in increased ability to monitor performance and decision making of managers (Harjoto & Jo, 2011). Higher objectivity increases the ability to monitor managerial decision making. The increased effectiveness of independent directors reduces opportunistic behavior of managers, leading to corporate strategies that are aimed at taking stakeholder interests into account. Independence of directors is therefore positively related to ethics strategy, consisting of CSR performance and paying high effective tax rates. Hypothesis 2: Board independence is positively associated with ethics strategy. Corporate decisions on taking stakeholder interests into account are determined by the contractual environment of firms. This ‘contractual environment’ of firms shows strong differences across nations, as a result of specific legal rules and enforcement mechanisms (Liang & Renneboog, 2017: pp 854-855). The legal regime impacts arrangements between stockowners and other stakeholders of firms by impacting “governance structures and the decision-making process” (Liang & Renneboog, 2017: pp 855). This paper integrates the effects of governance by investigating international legal and institutional differences. Based on legal origins theory, variations in investor protection exist between countries (La Porta et al., 1998). These differences result from origins of law systems. A distinction is made between common law and civil law systems. Common law is of English origin and revolves around precedential decisions of judges, courts and tribunals. Civil law has roots in early Roman law, using codified fundamental principles. “[B]eing a shareholder (...) in different legal jurisdictions entitles an investor to very different bundles of rights” (La Porta et al., 1998: pp 1151). Countries with common law systems are found to have stronger investor protection. In countries with higher levels of investor protection, investors are less exposed to rent seeking of managers (La Porta et al., 1997: pp 1149).
Investor protection works as an external corporate governance mechanism. Boards in countries with higher investor protection are better able to control managers. This increased control reduces incentives for managers to behave opportunistically. Managers in high investor protection countries will therefore be more inclined to behave in the interest of shareholders and other stakeholders. These managers will implement ethics strategy, consisting of high CSR performance and paying high effective tax rates. Hypothesis 3: Investor protection is positively associated with ethics strategy. Investor protection does not only directly reduce the incentive for managers to behave opportunistically. It provides a solid legal and institutional basis for monitoring of managers. This better legal and institutional environment increases the functioning of governance mechanisms. Boards are better able to apply and use their expertise, experience and objectivity in an environment that allows for effective monitoring. The ‘bundle of rights’ that investors are entitled to in countries with high levels of investor protection, are used and enforced by boards to control managers. In countries with high levels of investor protection, this protective ‘bundle of rights’ facilitates boards to use their expertise, experience and objectivity more effectively. The impact of expertise and experience of boards on ethics strategy is larger in countries with high levels of investor protection. This is caused by the better legal and institutional environment in high investor protection countries, that equips non-executive directors with the legal and regulatory environment to better control managers. This reduces incentives for managers to behave opportunistically. Managers will therefore be more inclined to behave in the interest of shareholders and other stakeholders. These managers will implement ethics strategy, consisting of high CSR performance and paying high effective tax rates. Hypothesis 4: Investor protection is positively associated with the relation between board size and ethics strategy.
Hypothesis 5: Investor protection is positively associated with the relation between board
III. Research methods and data
3.1 Research design To investigate the relation between governance mechanisms and ethics strategy, an empirical research method is used. Of the approximately 45.000 listed firms worldwide, the sample includes 11.108 companies, headquartered in 91 different countries. Not all listed firms in the world are included, due to non-availability of data. Data is collected for the years 2005 until 2016. This research does not include earlier data, because the ASSET4 A4IR corporate social responsibility scores are not defined before 2005. This is a recent and sufficient time frame for testing the hypotheses. The dataset comprises a range of variables collected from multiple databases. Table 1 provides an overview of the variables, as well as their calculation and source database. The effective tax rate is incorporated in in this investigation by using the average five-year effective tax rate. This variable is selected because it excels at giving a good perspective on actual tax avoidance of corporations by strongly reducing the impact of two problems in tax avoidance measurement. First, this method offsets changes in deferred tax liabilities and deferred tax assets through calculating a five years average. The second potential problem is the ‘tax exhaustion’ problem (Desai et al, 2006: pp 26). This problem entails that in order for previous losses to be offset, sufficient profits have to made. “A crucial determinant of the incentives to engage in tax avoidance is the availability of tax shields.” (Desai et al, 2009: pp 538). This problem is also no longer an issue since the five-year averaged rate reduces the impact of incidental annual unavailability of tax shields substantially. A five-year interval is chosen since “annual cash effective tax rates are not very good predictors of long-run cash effective tax rates and, thus, are not accurate proxies for long-run tax avoidance.” (Dyreng, Hanlon & Maydew, 2008: pp 61). Calculating an average effective tax rate for an interval of over five years would be suboptimal due to a decrease in time variance of the data.
TABLE 1
Variable names and origins
Abbreviation Variable name Computation Data source
Dependent variables
1 ETR Five-year effective tax rate Available in database Asset 4 2 A4IR Environmental, social and Available in database Asset 4
governance factor
Independent variables
3 BSZ Board size Available in database Asset 4 4 BIN Board independence Available in database Asset 4 5 IPR Investor protection Available in database Worldbank 6 BSZ*IPR Moderator BSZ*IPR Variable '3 times variable '5' See source
variables
7 BIN*IPR Moderator BIN*IPR Variable '4' times variable '5' See source
variables
Independent control variables
8 ROA Return on asset Available in database Compustat Global 9 RDE Research and development Natural logaritm of value Compustat Global 10 DEQ Debt to equity ratio Available in database Compustat Global 11 SIZE Value of assets Natural logaritm of value Compustat Global 12 WGI Word governance indicators Principal component factor Worldbank
of value This table presents the variables, their (un)abbreviated names, computation and origin in their respective categories. Corporate social responsibility is measured by the A4IR rating collected from ASSET4. This rating integrates performance of companies on the pillars of economic-, environmental-, social- and corporate governance. The score is based on more than 250 indicators, integrating over 750 data points linked to public data sources. Board characteristics are amassed from ASSET4. These characteristics are board size and board independence. Board size is measured as the total number of board members at the end
of the fiscal year. Board independence is the percentage of board members reported to be independent by the corporation. Independence refers to absence of pecuniary or material relationships with the firm or affiliates, outside the professional compensation.
Investor protection scores, published by the World Bank, are used to investigate the relation with ethics strategy. Both the direct relation with ethics strategy and the moderating effect of investor protection on the relation between governance mechanisms and ethics strategy is investigated. To this end, the interaction terms of investor protection with both board size and board independence are computed and included in the regression model. Return on assets, research and development expenditure, net debt to equity ratio, the book value of total assets and the national ‘world governance indicator’ score are included as control variables to provide more robust inferences. Firms with better financial performance are better able to invest in stakeholders (Waddock & Graves, 1997). The net debt to equity ratio is controlled for, because firms with high leverage “generate and retain cash” aimed interest payments, limiting availability of funds for other stakeholders (Barnea & Rubin, 2010; Jizi et al., 2014: pp 607; Reverte, 2009). Size is controlled for, because larger firms have more impact on communities (Barnea & Rubin, 2010). This larger impact is positively related to corporate social responsibility performance. Consistent with earlier research I also include research and development expenditure (Martínez-Ferrero et al., 2017). The control variable on national level is the World Governance Indicator (WGI) score. This score is amassed form the World Bank website. The WGI scores represents governance performance in six categories: voice and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rule of law and control of corruption. Scores are assigned based more than 30 distinct sources, using information from (expert) individuals and corporations from all over the world. To prevent multicollinearity issues the highly correlated World Bank governance scores (WGI) are merged into a single factor, using a principal component analysis. The world governance indicators are controlled for to incorporate national differences in governance that limit managerial opportunism.
Conform best practice, all dependent and independent variables, including control variables, are winsorized at the third standard deviation from the mean. The effective tax rate is winsorized at one hundred percent and the control variable ‘net debt to equity ratio’ is trimmed at the third standard deviation, to reduce the impact of outliers. Natural logs of the variables: research and development expenditure and size measured in assets are used, to increase robustness of results. Research and development expenditure is scaled to offset inequality in size.
An International dataset is used to investigate the relation between governance mechanisms and ethics strategy. Firms of all industries are included and categorized using the Fama-French 12-industry classification. An overview of the distribution amongst different industries is presented in appendix A. To control for operation in distinct industries, industry fixed effects are used. Year fixed effects are incorporated, to control for variations caused by timing. The specifications of this investigation of the relation between governance mechanisms and ethics strategy result in the regression equations presented below in equation 1 and equation 2. The first equation displays the model for investigation of the relation between governance mechanisms and the average five-year effective tax rate. The second equation presents the model for investigation of the relation between governance mechanisms and the asset 4 corporate social responsibility score. The unabbreviated names and the origin of the variables referred to in the regression equations below are presented in table 1. !"# =∝ + ()*+,-.+ (/*01-.+ (203#-. + (4*+, ∗ 03#-.+ (6*01 ∗ 03#-. + (7#89-. + (:#;!-.+ (<;!=-. + (>+0,! + ()?@A0-.+ 0BCDEFGHIE-. + JIKGE-.+ ∈ (1)
940# =∝ + ()*+,-.+ (/*01-.+ (203#-.+ (4*+, ∗ 03#-.+ (6*01 ∗ 03#-. + (7#89-. + (:#;!-.+ (<;!=-. + (>+0,! + ()?@A0-.+ 0BCDEFGHIE-. + JIKGE-.+ ∈ (2) 3.2 Approach to ethics Pursuant deontological ethics, motives rather than outcomes discern. Good actions in terms of outcome, are morally meritorious when emerging from a sense of duty. Contrary, good consequences accomplished through bad aspirations, like ‘self-interest’, are not (Husted & Allen, 2000: pp 28-29). According to deontological ethics, prevailing is whether corporations pay tax because it is their duty or because it is in their own interest to do so. A ‘contradictio in terminis’ is at hand, when using deontological ethics to assess ethics strategy. Good actions emerging from self-interest would be considered not ethical, and corporate conduct not aimed at value creation prospering the firm is by nature ‘not strategic’ (Husted & Allen, 2000: pp 28). A deontological perspective is not suitable for evaluating ethics strategy. Consequentialism is a more suitable stream of ethics for evaluation of ethics strategy. This normative ethical theory prevails outcomes rather than intentions in assessing morality. Higher tax income gives means to the government to bring about higher utility. Higher corporate tax outlay relative to the total profits before taxes is more ethical. Because strategy is about goal achievement, the magnitude of strategy is best evaluated by scrutinizing goal realization. In a strategy setting, consequential ethics are more suitable than deontological ethics for assessment of morality.
3.3 Research data
The descriptive statistics of the data are reported in table 2. Usage of different data sources and missing observations resulted in differences in the number of observation amongst variables. Negative minimum values for the independent non-control variables are a result of standardization procedures previous to computation of the interaction terms. The minimum debt to equity ratio is negative, because net debt to equity ratios are used. This makes negative ratios possible for firms with high cash holdings and low asset values. Negative minimum values for WGI scores are a result of standardized source values. Negative minimum values for the variables firm size and research and development expenditure result from natural logarithm transformations. TABLE 2 Descriptive statistics
N Min Max Mean Std.deviation
Dependent variables 1 ETR 34390 0,000 100,000 19,165 17,837 2 A4IR 35997 0,000 98,190 39,664 34,290 Independent variables 3 BSZ 38647 0,000 24,430 8,392 5,290 4 BIN 38633 0,000 95,280 39,559 34,645 5 IPR 97350 3,747 8,300 6,297 0,843 6 BSZ*IPR 33753 -6,466 4,800 0,037 0,965 7 BIN*IPR 33740 -3,221 3,823 0,213 0,892 Independent control variables 8 ROA 99261 -36,697 36,554 0,005 0,639 9 RDE (log) 39654 -3,467 5,072 1,501 1,112 10 DEQ 109541 -304,585 305,534 0,871 7,500 11 SIZE (log) 109671 -0,360 7,717 3,880 1,240 12 WGI (pca) 68244 -2,377 1,512 0,000 1,000 This table presents the descriptive statistics of the variables in the sample. Displayed are the number of observations (N), minimum value (Min), maximum value (Max), mean value (Mean) and the standard deviation (Std.deviation) for all variables in the sample in their respective categories. The unabbreviated names, computation and origin of the variables can be found in table 1. (log) refers to natural logarithm and (pca) refers to principal component analysis.
Table 3 presents the correlations of the variables in the sample. Noteworthy is the positive high correlation between the firm level control variables: research and development expense and firm size. This high correlation reflects that larger firms invest more in research and development. Both interaction terms show a high positive correlation, because they are computed using one identical variable. This use of the investor protection scores in both interaction terms results in a high positive correlation between the moderating variables. Furthermore, this high correlation is caused by a high positive correlation between board size and board independence, the other variables used to compute the interaction terms. The positive correlation between board size and board independence indicates that larger boards tend to have relatively more independent directors. The high positive correlation of these variables with the A4IR corporate social responsibility score indicates that both larger and more independent boards are positively correlated with CSR performance.
Additional tests, using variance inflation factor (VIF), show that the high correlations are of no concern, because the highest observed VIF value (3,892) is substantially below the acceptable threshold (VIF =10) (Kutner et al., 2004: pp 409). I conclude that there are no multicollinearity problems in the specified regression models.
TABLE 3 Correlations 1 2 3 4 5 6 7 8 9 10 11 12 Dependent variables 1 ETR 1 ,126** ,142** ,031** -,021** ,010 ,001 ,124** ,075** ,004 ,092** ,010 2 A4IR ,126** 1 ,596** ,489** ,133** ,164** ,126** ,028** ,120** ,031** ,140** ,225** Independent variables 3 BSZ ,142** ,596** 1 ,390** ,030** ,149** ,189** ,001 ,219** ,034** ,274** ,093** 4 BIN ,031** ,489** ,390** 1 ,197** ,173** ,228** ,008 -,198** ,018** -,158** ,175** 5 IPR -,021** ,133** ,030** ,197** 1 -,174** -,129** -,018** -,207** ,009** -,124** ,252** 6 BSZ*IPR ,010 ,164** ,149** ,173** -,174** 1 ,536** -,001 -,051** ,004 ,033** ,061** 7 BIN*IPR ,001 ,126** ,189** ,228** -,129** ,536** 1 -,009 ,083** ,002 ,059** -,004 Independent control variables 8 ROA ,124** ,028** ,001 ,008 -,018** -,001 -,009 1 ,032** ,011** ,126** -,034** 9 RDE ,075** ,120** ,219** -,198** -,207** -,051** ,083** ,032** 1 ,012* ,660** ,179** 10 DEQ ,004 ,031** ,034** ,018** ,009** ,004 ,002 ,011** ,012* 1 ,032** ,008* 11 SIZE ,092** ,140** ,274** -,158** -,124** ,033** ,059** ,126** ,660** ,032** 1 -,028** 12 WGI ,010 ,225** ,093** ,175** ,252** ,061** -,004 -,034** ,179** ,008* -,028** 1 This table presents the correlations of the variables. The unabbreviated names, computation and origin of the variables can be found in table 1. * and ** represent a 5% and 1% significance level. __________________________________________________________________________________________________________________________________
IV. Results
The aim of this paper is to investigate how governments and shareholders can induce corporate decision makers to implement ethics strategy, and if performance on the components of ethics strategy is affected symmetrically. To this end, the association between governance mechanisms and tax payment and the association between governance mechanisms and CSR performance are investigated. The governance mechanisms under investigation are board size, board independence and national investor protection. This paper is intended to defragment the discussion on CSR and tax avoidance, using an agency theory framework in an international setting. The results of the investigation are presented in table 4. This table presents the association between the independent variables and the dependent variables: effective tax rate and corporate social responsibility performance. Model one, two and three present the results for the association with effective tax rate. Model four, five and six display the results for the association with corporate social responsibility performance. The explanatory value of the regression models one, two and three is relatively low compared to the explanatory value of regression model four, five and six. In the first three models, approximately 9,5 percent of the variance is explained by the model. In model four, five and six the percentage of variance explained by the model is close to fifty percent. Therefore, although specifically model one, two and three have to be interpreted with care, conclusions can be drawn from the outcomes of all six regression models. Below the results are discussed, following the order of the five hypotheses. The first hypothesis posits that board size is positively associated with ethics strategy. The results support the hypothesis. Board size is positively associated with both components of ethics strategy. This finding is in line with the agency theory view of stakeholder theory. Cumulative expertise and experience of larger boards helps to control managers. By controlling managers, corporate decision making is aimed at taking the interest of stakeholder into account.TABLE 4 Main results Effective tax rate Corporate Social Responsibility Model 1 2 3 4 5 6 Independent variables BSZ ,101 *** ,098 *** ,102 *** ,366 *** ,373 *** ,364 *** BIN -,019 -,014 -,020 ,386 *** ,369 *** ,388 *** IPR ,070 *** ,067 *** ,069 *** ,163 *** ,177 *** ,166 *** BSZ*IPR -,030 *** ,093 *** BIN*IPR -,010 ,019 ** Control variables ROA ,153 *** ,155 *** ,154 *** ,030 *** ,030 *** ,030 *** RDE ,003 ,004 ,004 ,082 *** ,081 *** ,081 *** DEQ -,031 *** -,031 *** -,031 *** ,013 ,014 * ,013 SIZE ,220 *** ,220 *** ,220 *** ,090 *** ,093 *** ,091 *** WGI ,089 *** ,091 *** ,089 *** ,195 *** ,191 *** ,195 *** Fixed effects
Industry Yes Yes Yes Yes Yes Yes
Year Yes Yes Yes Yes Yes Yes
N 7587 7587 7587 7762 7762 7762 Adj. r square ,095 ,095 ,095 ,491 ,499 ,491 Max. VIF 3,616 3,616 3,617 3,891 3,892 3,892 This table presents the main results of the investigation. Displayed are the results for the six regression models. In model 1, 2 and 3, the effective tax rate is the dependent variable. In model 4, 5 and 6 corporate social responsibility is the dependent variable. Industry and year fixed effects are used for all six models. Displayed are the number of observations (N), adjusted r-squared value (Adj. r square) and the highest observed variance inflation factor for all models. The unabbreviated names, computation and origin of the variables can be found in table 1. ***, ** and * represent a 1%, 5% and 10% significance level. The second hypothesis posits that board independence is positively associated with ethics strategy. No evidence is found of association between board independence and the effective tax rate. This finding is not in line with the hypnotized association. I do not find support for the
provide evidence of a positive association between board independence and corporate social responsibility performance. This finding is in line with the agency theory view of stakeholder theory, that posits that board independence helps to control managers. This better control results in corporate strategies that take into account stakeholder interest, indicated by high CSR performance.
The third hypothesis predicted that investor protection is positively related to ethics strategy. The results support this hypothesis. The association is found for both components of ethics strategy: the effective tax rate and corporate social responsibility performance. This finding is in line with the agency theory view of stakeholder theory. The legal rules and enforcement mechanisms in countries with high levels of investor protection work as an external governance mechanism. Investor protection reduces the incentives for managers to behave opportunistic and leads to corporate strategies that focus on interests of other stakeholders.
The fourth hypothesis posits that investor protection is positively associated with the relation between board size and ethics strategy. This hypothesis leads to different findings for dependent variables, the components of ethics strategy: the effective tax rate and corporate social responsibility performance. Contrary to the hypnotized relationship, investor protection is negatively associated with the relation between board size and the effective tax rate. This finding is not in line with the expectation that in countries with high levels of investor protection, larger boards are better able to use their higher level of cumulative expertise and experience to reduce tax avoidance.
Investor protection is positively associated with the relation between board size and corporate social responsibility performance. This is in line with the agency theory view of stakeholder theory and the expectation that in countries with high levels of investor protection, larger boards are better able to use their higher levels of cumulative expertise and experience to induce better corporate social responsibility performance. The contrasting findings for the components of ethics strategy are further examined in the conclusion and discussion section.
The fifth hypothesis predicts that investor protection is positively associated with the relation between board independence and ethics strategy. The results indicate an association for one of the two components of ethics strategy. No evidence is found for an association between investor protection associated with the relation between board independence and the effective tax rate. This finding is not in line with the hypnotized association. Investor protection is significantly positively associated with the relation between board independence and corporate social responsibility. This is in line with the agency theory view of stakeholder theory and the expectation that in countries with high levels of investor protection, more independent boards are better able to use their objectivity to improve monitoring and controlling, resulting in higher corporate social responsibility performance.
V. Conclusion and discussion
Based on stakeholder theory, all stakeholders are important for the success of corporations. Taking stakeholder interests into account, is argued to function as a risk management mechanism for firms. Therefore, it is in the interest of shareholder to take other stakeholders their interests into account. Based on agency theory, managers are considered to be opportunistic. Through private rent extraction managers misappropriate corporate funds reserved for other stakeholders. The aim of this paper is to investigate how governments and shareholders can induce corporate decision makers to implement ethics strategy, and if performance on the components of ethics strategy are affected symmetrically. To this end, the association between governance mechanisms and tax payment and the association between governance mechanisms and CSR are scrutinized. Specifically, board size, board independence and national investor protection are the governance mechanisms under investigation. This paper is intended to defragment the discussion on CSR and tax avoidance, using an agency theory view and international sample. The results indicate an asymmetric relation between governance mechanisms and the components of ethics strategy.
The findings indicate that governance mechanisms are positively associated with corporate social responsibility performance. Specifically, board size, board independence and investor protection are positively associated with corporate social responsibility performance. The results of this investigation support the expectation that in countries with higher levels of investor protection, larger and more independent boards are better able to use their higher relative independence and cumulative expertise and experience, in inducing ethics strategy. These findings are consistent with the agency theory view of stakeholder theory. This view entails that higher levels of cumulative expertise and experience of larger boards, higher proportions of independent directors and higher levels of investor protection help to control managers. Through increased control, corporate decision making is aimed more at taking the interest of stakeholders into account. This results in higher corporate social responsibility performance for firms with high levels of governance.
The results indicate that the governance mechanisms, board size and investor protection, are positively associated with effective corporate income tax rates. This finding is consistent with the agency theory view of stakeholder theory. In line with this view higher levels of cumulative expertise and experience of larger boards and higher levels of investor protection help to control managers. Through increased control, corporate decision making is aimed more at taking the interest of stakeholders into account, resulting in higher corporate income tax payments of firms with high levels of governance. No evidence is found of an association between board independence and tax avoidance and no evidence of the association of investor protection with an expected relation between board independence and tax avoidance. Interestingly, the results indicate a substituting relation between board size and investor protection in association with tax avoidance. This finding is in contrast with the expectation that in countries with high levels of investor protection, larger boards are better able to use their higher cumulative levels of expertise and experience in prevention of managerial reductions of corporate tax outlay. This indicates that in countries with high investor protection, higher levels of cumulative expertise and experience of larger boards have a reduced impact on tax aggressive strategies. In countries with low levels of investor protection, higher levels of cumulative expertise and experience of larger boards, have a relatively stronger association with effective tax rates.
The findings of this paper have several practical implications for shareholders and governments. To promote corporate social responsibility, shareholders should advocate for larger and more independent boards that monitor the managers of their organization. Changing the national level of investor protection is complex. Building on legal origins theory, investor protection is largely determined by the origin of the legal system. By modifying laws, governments can make modest adjustments in order to increase the level of investor protection, resulting in better corporate social responsibility performance. This higher investor protection strengthens the association of larger and more independent boards with corporate social responsibility.
aggressiveness. In high investor protection countries, increasing the size of boards is less effective in reducing tax aggressiveness. In these countries, the higher levels of cumulative expertise and experience are less effective in inducing managers not to avoid tax.
Only listed firms are investigated in this paper. The conclusions are not generalizable to smaller unlisted firms. In this paper, only corporate income tax is investigated. Future examination of other types of taxation would be a neat addition to this paper. One can argue that payment of tax to authoritarian regimes is unethical. This is beyond the scope of this study. Future research could investigate whether controlling for payment to oppressive regimes influences the conclusions. Future studies may also investigate the cause of the asymmetry in the association between governance mechanisms and tax avoidance and the association between and governance mechanisms and corporate social responsibility.
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