Companies whose earnings are out of sync with the rest of their industry are more likely to misreport them.
Based on research by Karthik Balakrishnan, Jennifer L. Blouin and Wayne R. Guay
Avoiding Taxes Can Have Unintended Consequences
- Corporations that prioritize tax-avoidant strategies more than their peers are considered "tax aggressive."
- Tax aggressiveness comes at the cost of lower corporate transparency.
- Analysts make more, and more varied, errors when evaluating tax aggressive corporations.
Do you know how much tax ExxonMobil pays? Chevron? Bank of America? You probably don't. Depending on the company, even the most astute analyst may not either.
Let's try an easier question. If you compare a large, multinational corporation with a local pizza chain, you might suspect the multinational pays proportionally less tax than the pizza joint. You may be right — but you’d have a hard time proving it.
Rice Business professor Karthik Balakrishnan, along with Jennifer L. Blouin and Wayne R. Guay from the University of Pennsylvania, developed a sophisticated method to prove the real costs of corporate tax policy. Specifically, they devised a mathematical formula that measures tax aggressiveness, the extent to which a corporation uses strategies to pay less tax than its peers.
In a key innovation, the model that Balakrishnan and his colleagues created didn’t initially compare businesses like the multinational to those like the pizza chain. Instead, they built the formula to include comparable corporation size and industry into the measure of tax aggressiveness. A domestic pharmaceutical company, they point out, will have a lower tax rate than a domestic food distributor, simply because the pharma company is likely eligible for greater research and development tax credits. This is the reason that individual tax rates alone don’t show if either the pharma company or the food distributor is being particularly aggressive.
Businesses of all sizes, as well as individuals, engage in tax strategy: finding ways to lower the amount of tax they need to pay. But large corporations can be more aggressive than our restaurant chainlet because a corporation has the money to pay associated costs. These might include hiring the legal and accounting muscle to take advantage of credits and loopholes; the funds to pay penalties if they stray into legally grey zones; and the human resources to run numerous companies under one umbrella. As any business does, corporations constantly weigh the costs and benefits of their endeavors.
Balakrishnan and his colleagues argue there is a cost to tax aggressiveness that has not been properly documented: corporate transparency. Sophisticated tax strategies, they write, can require circuitous capital and compartmentalized activities, both of which make it hard for outsiders to learn the source and persistence of a firm’s earnings.
There’s a reason, in other words, why you can’t quite pin down whether a large multinational is paying less tax than a restaurant chainlet. The multinational may be threading its tax strategy through so many loopholes that even analysts and investors lose their way. This means a multinational’s shareholders must weigh the gains of tax savings against the wish for corporate transparency.
For corporations, the researchers argue, that lack of transparency has an economic cost. Setting aside ethical priorities, fewer people will want your stocks if they can't understand exactly what they are worth. One measure of this confusion is the bid-ask spread, that is, the difference between a stock's asking price and what an investor is willing to pay. The more tax aggressive a company is, the researchers found, the higher the bid-ask spread. When a corporation is highly tax aggressive, they also found, analysts make more — and more varied — mistakes trying to forecast the value of its assets.
So if you're a manager, it pays to understand the real cost your tax strategy represents. If you're an investor or an analyst, a consumer who cares about corporate social responsibility or just a taxpayer interested in how your country is funded, it’s in your interest to ask not only how much tax a corporation pays, or how much its stock is worth — but how easy it is to find out.
Karthik Balakrishnan is an associate professor of accounting at Jones Graduate School of Business at Rice University.
To learn more, please see: Balakrishnan, K., Blouin J. L. & Guay, W. R. (2019). Tax aggressiveness and corporate transparency. The Accounting Review, 94(1), 45-69.