Topic: different measures of tax avoidance

LITERATURE REVIEW ON METHODS OF MEASURING CORPORATE TAX AVOIDANCE

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Literature Review on Methods of Measuring Corporate Tax Avoidance

Meaning of Corporate Tax Avoidance

Corporate Tax Avoidance (CTA) has diverse meaning according to different people’s viewpoints just like many other management terminologies and therefore it does not have a general universal definition. Moreover, scholars assert that corporate tax avoidance practices are inaccurately defined due to the general misunderstandings about tax avoidance as a legitimate act (Lanis and Richardson, 2011, p. 2). Although there is a clear definition of tax law violations, the general classification of tax avoidance as legitimate and evasion as unlawful activity respectively by economic and law professionals has been termed as an insufficient conclusion and the legitimacy of any tax activities cannot easily be established. The variation between what is legitimate and illegal in the management of tax appears to be too narrow to warrant a clear contrast. As a result, the terms like tax aggressiveness, planning, and management are often used interchangeably to mean tax avoidance in various literature. This reflects the broad perception of the definition of tax avoidance, which is further reinforced, by the definitions given in recent literature.

Tax avoidance as suggested by Dyreng, Hanlon and Maydew, (2008) is the capacity to pay small quantity of tax per dollar of stated pre- tax financial accounting revenue. One the other hand Frank, Lynch and Rego, (2009) asserts that CTA is the downward manipulation of total income that is taxable through tax planning which may either or not be considered as a fraud of evading tax. More explicitly, it is viewed by Chen Chen, Cheng and Shevlin, (2010) to encompass a tax planning practices that may fall in a gray area or are legitimate as well as illegal. This definition is several individuals in their studies such as lanis and Richardson (2011) as it seems to be more broad and explicit. However, a more encompassing meaning is given by Hanlon and Heitzman where they presented avoidance of tax as a chain of tax planning tactics in which items like bond investments are at one end while sheltering, aggressiveness and evasion are near other end of the sequence. In this regard, they defined the term as explicit taxes reduction. This viewpoint reflects all transactions that impact the clear tax liability of an organization.

Measures of Tax Avoidance

Measurement of tax avoidance depends on two main factors, which include tax liability and taxable income. The first factor is used to estimate the amount of the income paid and payable as taxes in a firm while the second one assist in assessing the gap between taxable and accounting incomes (Wilson, 2009, p.2). The information of the two can be found in either annual financial statements or tax returns in the files of a company. However, the information from both sources may differ due to divergences in regulatory laws and objectives of financial together with tax accounting systems. Although tax returns provide accurate information about a firm, they are confidential and only accessible to few individuals. As a result, financial statements are the most preferred sources to estimate tax avoidance. The review and studies of the measures that have employed them are discussed below.

Effective Tax Rate (ETR)

ETR is the most regularly used method of estimating CTA because it assists in estimating how much tax planning activities of a firm are effective. Although it is calculated as the ratio of tax liability to accounting revenue, some variations have been filed in different kinds of literature, which include accounting, long- run cash, current, income tax expense and cash taxes paid.

Accounting ETR

In USA context, it is known as GAAP ET. It is usually measured as the overall tax expenditure divided by accounting revenue prior tax. In this regard, it represents the total percentage of the accounting revenue that can be paid as tax and estimates CTA relative accounting income. The measure was used by Chen et al. (2010) to establish tax aggressiveness among a thousand and three companies on S&O index to show the association between tax avoidance and family ownership.

The measure was further used by Dyreng et al. (2010) although certain items were adjusted to measure CTA while evaluating the impact of the top executive on tax avoidance. Likewise, Armstrong, Bluin and Larker used the measure to analyze the impact of tax directors on CTA in 2012 while Huseynov and Klamm (2012) employed it while studying the association between some measures corporate tax avoidance and corporate social responsibilities disclosure. Although the method is used widely as a measure of CTA and only compute non-conforming avoidance of tax because the method measure avoidance of tax relative to accounting income. Also, the computing technique may fail to reflect the tax deferral strategies as it uses aggregate tax expenses.

Current ETR

The procedure is somewhat different from accounting ETR in that effective tax rate is computed as the present annual tax expense to the whole accounting revenue prior taxation. It shows the firm’s plans of tax deferral using present income tax in contrast to overall tax expense, which represents better approach of estimating CTA as compared to accounting ETR. Motivated by this merit, Hope, Ma and Thomas (2012) employed it to estimate tax avoidance in their examination of relationship between disclosure practices of geographical earnings and CTA among multinational companies in US.

Correspondingly, Lanis and Richardson (2012) used the method to calculate tax aggressiveness in a study that was aimed at determining the association between tax aggressiveness and corporate social responsibilities in 408 enterprises based Australian. However, although the strategy seems better suited to calculate ETR since it shows the deferral strategies of a company, it can only capture the non-conforming form of CTA. Also, the current and accounting ETR are vulnerable to volatility annual -to- annual problem and therefore it cannot reflect tax avoidance over a long period.

Long- Run Cash (LRC) - ETR

LRC- ETR is a portion of cash taxes is paid to the accounting revenue before taxation. According to Dyreng et al., (2008) utilization of cash amount of tax instead of tax expense assists in minimizing the potential impact of items such as tax cushions and valuation allowance. According to Minnick and Noga, (2010), the cash tax calculated effective tax rate encompasses the tax advantages of workers stock opportunities, which is not accounted for in accounting ETR computation. Additionally, the long-run cash ETR as argued by Hanlon and Hietzman (2010) uses tax information from several years ranging from 3 to 10 years, which assist in eliminating volatility present in year level measures.

Understandably, the volatility in CTA computation is normally produced by timing variation between treatments of some things under tax and financial accounting. In other words it is also referred as impermanent variation. Dyreng et al., (2008) posits that the volatility disappears with time and therefore tax avoidance require to be computed using several years data rather than yearly data. Other studies such as Hope et al., (2012), Dyreng et al., (2010), and Minnick and Noga (2010) employed LRC-ETR to compute tax aggressiveness/ avoidance in addition to either current ETR or accounting ETR with varying time of between 3 to 16 years level evaluation.

Income Tax Expense-ITE

It has been posited that calculating percentage of ITE in relation to operating cash flow (OCF) is a better estimation method of corporate’s tax burden. Zimmerman suggested that replacement of accounting income with (OCF) assist in reflecting the real tax burden of an organization since it eliminates the impacts of accrual accounting measures. Comparable assertions can be found in later studies done by Buijink, janssen and Schols in 2012. In this regard, Lanis and Richardson (2012) in relation to their earlier proposal in 2007 employed the procedure to evaluate tax aggressiveness among 408 firms based in Australia while determining the relationship between tax aggressiveness and corporate social responsibilities. It should be noted that though the procedure overpowers the challenges of employing accrual element as the denominator, the incorporation of ITE makes it vulnerable to impacts of accrual bias. As a result, the measuring procedure only reflects the non-conforming CTA.

Cash Taxes Paid (CTP)

This measure proposed by Hanlon and Hietzman (2010) as an alternative to income tax expense. The use of CTP and OCF ratio of an organization is perceived to estimating CTA in an approach that is not comparative to accrual accounting thereby reflecting conforming avoidance of tax. However, the measure has not yet been proven practically.

Book-Tax Gap (BTG)

These methods of estimating CTA center on the magnitude variation between taxable revenue (BTG) and accounting returns. Though the causes of book-tax gap are numerous and normally classified as temporary and permanent variations, the gap size suggests the tax avoidance presence. To support these arguments Mills, (1998) studied and found a positive association between BTG, tax audit and large adjustment among different firms in US. There are two main BTG measures used to capture CTA, which include total and residual respectively.

Manzon and Plesko (2002 created the model of calculating total BTG while Chen et al. (2010) used it to measure tax aggressiveness among corporates in USA. Since total BTG can be affected by the earnings management practices of a corporate as posited by Desai and Dharmapala in 2006 in their study that tried to capture the unexplained portion of the model, Hanlon and Hietzman (2010) developed residual BTG. In 2011, Tang and Firth developed another BTG measure form termed as a tax-effect book-tax gap. The individuals argued that the former two main measures use the general firm income tax rate and are therefore income tax book-tax gap. However, tax-effect BTG focuses on variation between current and income tax expenses and therefore suitable in a setting of corporate where organizations are subjected to diverse rates of taxes.

DTAX

DTAX is a differential effective tax rate measure of CTA, which focuses on variations between organization’s ETR and statutory firm’s income tax rate. The unexplained ETR portion disparity is represented within its differentiation provided by Frank et al. (2009). Afterwards, Armstrong Blouin and Larcker, (2012) used the model together with other measures of CTA in their study aimed at determining the impact of tax director’s reward on tax aggressiveness. The measure is suitable to employ when studying the second extreme end of the sequence in Hanlon and Hietzman (2010) study of tax avoidance.

Tax Shelter Measures

The model of estimating tax sheltering by firms was developed by Wilson (2009). The individual used the profile of companies charged with tax shelter fraud in USA. This model has since been significant in assessing CTA practices. In fact, Armstrong et al. (2012) employed the measure in their study stated above in DTAX section. However, according to Hanlon and Heitzman 2010), though the model is suitable in estimating CTA its structure faces selection biases jeopardies. This is due to the sample used was from accused firms which mean that all companies were not captured since many do evade taxes without sheltering.

Conclusion

The evaluation of these previously used methods of estimating CTA reflected in this paper shows that many can capture non- conforming tax avoidance except the model given by Heitzman 2010 (Cash Taxes Paid). However, there are several other estimating tax avoidance besides these represented in the above literature review although they are not commonly used by researchers. In this regard, it is critical to prove the viability of cash taxes paid model since it seems to be the best means of measuring conforming tax avoidance. Numerous studies like in case of other methods require being carried to improve areas of weaknesses so that it can be a reliable model for estimating CTA just like other methods.

References

Dyreng, S.D., Hanlon, M. and Maydew, E.L., 2008. Long-run corporate tax avoidance. The Accounting Review, 83(1), pp.61-82.

Armstrong, C.S., Blouin, J.L. and Larcker, D.F., 2012. The incentives for tax planning. Journal of Accounting and Economics, 53(1), pp.391-411.

Buijink, W., Janssen, B. and Schols, Y., 2002. Evidence of the effect of domicile on corporate average effective tax rates in the European Union. Journal of International Accounting, Auditing and Taxation, 11(2), pp.115-130.

Chen, S., Chen, X., Cheng, Q. and Shevlin, T., 2010. Are family firms more tax aggressive than non-family firms? Journal of Financial Economics, 95(1), pp.41-61.

Frank, M.M., Lynch, L.J. and Rego, S.O., 2009. Tax reporting aggressiveness and its relation to aggressive financial reporting. The Accounting Review, 84(2), pp.467-496.

Hanlon, M., & Heitzman, S. (2010). A review of tax research. Journal of Accounting and Economics, 50(2), 127-178.

Huseynov, F. and Klamm, B.K., 2012. Tax avoidance, tax management and corporate social responsibility. Journal of Corporate Finance, 18(4), pp.804-827.

Huseynov, F. and Klamm, B.K., 2012. Tax avoidance, tax management and corporate social responsibility. Journal of Corporate Finance, 18(4), pp.804-827.

Lanis, R. and Richardson, G., 2011. The effect of board of director composition on corporate tax aggressiveness. Journal of Accounting and Public Policy, 30(1), pp.50-70.

Lanis, R., & Richardson, G. (2012). Corporate social responsibility and tax aggressiveness: An empirical analysis. Journal of Accounting and Public Policy, 31(1), 86-108.

Manzon Jr, G.B. and Plesko, G.A., The Relation Between Financial and Tax Reporting Measures of Income (May 2002) (No. 4332-01). MIT Sloan Working Paper.

Mills, L.F., 1998. Book-tax differences and Internal Revenue Service adjustments. Journal of Accounting research, 36(2), pp.343-356.

Minnick, K. and Noga, T., 2010. Do corporate governance characteristics influence tax management? Journal of corporate finance, 16(5), pp.703-718.

Tang, T. and Firth, M., 2011. Can book–tax differences capture earnings management and tax management? Empirical evidence from China. The International Journal of Accounting, 46(2), pp.175-204.

Wilson, R.J., 2009. An examination of corporate tax shelter participants. The Accounting Review, 84(3), pp.969-999.