Tax Avoidance, Tax Aggressiveness, Tax Risk and Firm Risk David

Tax Avoidance, Tax Aggressiveness, Tax Risk and Firm Risk

David A. Guenther, Steven R. Matsunaga*, Brian M. Williams

Lundquist College of Business, University of Oregon, Eugene, OR 97403 USA

August 2013

Abstract: In this study we distinguish between the concepts of tax avoidance, tax

aggressiveness, and tax risk and examine which, if any, of those concepts is related to overall

firm risk. Prior research has argued that aggressive corporate tax avoidance, as measured by low

cash effective tax rates or high reserves for unrecognized tax benefits, increases firm risk,

thereby requiring firms to provide risk-taking incentives to managers. In this paper we define the

concept of tax risk as the ability of a firm to sustain its tax positions over time and test whether

tax avoidance, tax aggressiveness, or tax risk are related to future stock return volatility. We find

a significantly positive relation between tax risk and firm risk, but do not find evidence of a

significant association between either tax avoidance or tax aggressiveness and firm risk.

JEL classification: M41

Key Words: effective tax rates; unrecorded tax benefit; tax aggressiveness; tax risk

*Corresponding author:

Professor Steve Matsunaga

Lundquist College of Business

1208 University of Oregon

Eugene, OR 97403-1208

Phone: (541) 346-3340

Fax: (541) 346-3341

email: [email protected]

We thank Kathleen Powers and the rest of the Texas Tax Reading Group, the Iowa Tax Reading

Group, Jenny Brown and the rest of the Arizona State Tax Reading Group, Michelle Hutchins,

Sonja Rego, Carlos Jiménez-Angueira and workshop participants at the University of Oregon,

the 2013 AAA Western Regional Meeting and the 2013 AAA Annual Meeting for helpful

comments. Support from the Finance and Securities Analysis Center at the Lundquist College of

Business is gratefully acknowledged.

1

Tax Avoidance, Tax Aggressiveness, Tax Risk and Firm Risk

1. Introduction

Surveys and other publications by tax practitioners have focused attention on the notion

of "tax risk" as a type of business risk that must be managed by public corporations.1 Tax risk

and its effect on public companies has also been the subject of academic research in accounting.

Since tax risk is by definition "risky," it has been argued that firms must provide risk-taking

incentives for managers to encourage them to undertake risky value-maximizing strategies that

reduce the firm’s tax payments (Brown, Drake, and Martin 2013; Rego and Wilson 2012; Boivie

et al 2012; Higgins, Omer and Phillips 2012; and Robinson, Xue, and Zhang 2012). Despite the

view that reducing corporate taxes is risky, there is a lack of empirical evidence linking tax-

reduction activities to an increase in firm risk.2

Managers adopt a wide range of tax policies designed to reduce firms’ corporate tax

payments, and researchers are not always consistent in either the terms used to describe these

policies, or the empirical measures used to identify them. Our goal in this study is to differentiate

between three different concepts that characterize tax policy—which we refer to as tax

avoidance, tax aggressiveness, and tax risk—and to propose appropriate empirical measures for

each concept.3 We then investigate whether any, or all, of the empirical measures are associated

with a well-accepted measure of firm risk: future stock return volatility.4 Our purpose is to

provide insight into how firms’ tax policies affect the overall risk of the firm.

1 See for example Ernst & Young (2011), KPMG (2011), and PricewaterhouseCoopers (2004).

2 In work that is somewhat related to our question, McGuire, Neuman and Omer (2013) examine how the

persistence of tax avoidance strategies affects earnings persistence, and Campbell, Chen, Dhaliwal, Lu, and Steele

(2013) examine how corporate effective tax rates are related to managers' discussion of tax risk in 10-Ks. 3 Our classification of three different concepts of tax policy is similar to the classification used in Lisowsky,

Robinson and Schmidt (2013). 4 We focus on the traditional view of firm risk as being reflected in the volatility of stock returns, since this is the

type of risk for which managers are compensated by the use of employee stock options.

2

In finance the term "risk" is generally used to describe the spread or dispersion of

possible outcomes or payoffs from an investment, reflecting the degree of uncertainty about the

future (Brealey and Myers 1991 p 114). Neuman, Omer and Schmidt (2013, 6) relate this

concept to corporate tax risk, stating: "Tax risk refers to the potential that a chosen action or

activity [...] will lead to a tax outcome that is different than initially expected." The simplest and

most commonly used measures of spread or dispersion are the standard deviation and variance of

the payoffs (Powers 2009). These have been the traditional measures of risk in academic finance

research for some time (e.g., Markowitz 1952) and continue to be used in current research (e.g.,

Cassel, Huang, Sancez, and Stuart 2012). Measuring risk as the variance or standard deviation of

expected outcomes or payoffs is also a standard approach in finance textbooks (e.g., Fama 1976;

Cochrane 2001; Pennacchi 2007).

To investigate the relation between a firm’s tax policies and firm risk, we consider three

underlying concepts that have been used to characterize firms’ tax policies. The first concept is

tax avoidance, which we define as adopting tax policies that reduce the firm’s income tax

payments. Following Dyreng, Hanlon, and Maydew (2008) we use the Cash ETR as the

appropriate measure of tax avoidance. Dyreng et al. (2008) describe a low Cash ETR as “the

ability to pay a low amount of cash taxes per dollar of pre-tax earnings over long time periods."

Tax policies that avoid more taxes, and lead to lower Cash ETRs, could increase the firm’s risk if

the underlying activities that allow the firm to lower tax rates are inherently risky, or if lower tax

rates are less sustainable than higher tax rates. On the other hand, the ability to avoid taxes has

been shown to be stable over long time periods (Dyreng et al. 2008). In this case, the firm’s tax

rate would be fairly stable over time, and the riskiness of the underlying activities may not be

3

different from similar more highly taxed investments, in which case tax avoidance activities

would not be associated with firm risk.

The second tax policy concept we examine is tax aggressiveness, which we define as the

extent to which the firm takes tax positions that are unlikely to survive a challenge by the I.R.S.

Tax avoidance differs from tax aggressiveness in that firms can lower their tax rates while still

taking tax positions that are unlikely to be overturned by the I.R.S. For example, opening a

subsidiary in a low tax country, taking advantage of accelerated depreciation deductions, or

qualifying for research and development tax credits would allow a firm to avoid paying income

tax in ways that would generally not be challenged by the I.R.S. and therefore would not

represent tax positions that are aggressive. On the other hand, if firms reduce their tax payments

by engaging in activities or interpreting the tax code in ways that would be unlikely to be upheld

if the firm were audited, they are exhibiting tax aggressiveness.

The empirical measure that appears to best capture the concept of tax aggressiveness is

the reserve for Unrecognized Tax Benefits (UTBs) as defined by FASB Interpretation No. 48

(FIN 48). FIN 48 was specifically created to limit the ability of firms to reduce their reported tax

expense by taking positions that are unlikely to be upheld in the future. Tax aggressive policies,

reflected in a high UTB reserve, could increase firm risk if there is a high degree of uncertainty

with regard to future tax payments. However, despite the name, it isn’t clear whether UTB

reserves actually reflect uncertainty about a firm’s future tax payments. Consistent policies

whereby new aggressive positions offset settlements could lead to fairly predictable tax

payments. In addition, the resolution of uncertain positions could take years to work through the

judicial system. Finally, the determination of the UTB reserve is subjective and is therefore

4

subject to the biases inherent in the accrual process. We therefore view the effect of UTBs on

firm risk as an empirical question.

The third tax policy concept we examine is tax risk, which we define as uncertainty

regarding the firm’s future tax payments. Tax risk differs from tax avoidance and tax

aggressiveness in that it reflects the extent to which a firm is able to sustain its tax positions over

time. A firm’s tax payments are likely to change over time for a variety of reasons, including

changes in domestic and international tax law, the extent to which aggressive tax positions are

settled for or against the firm, or the firm’s ability to maintain tax-favored investments.

Regardless of the source, variability in the firm’s tax rate should be reflected in uncertainty about

the tax rate investors should apply to pretax income or cash flows in assessing the firm’s future

after-tax cash flows. We use the standard deviation of the firm’s annual cash ETR to measure tax

risk.

As noted above, recent and concurrent research assumes or asserts that policies that

reduce the firm’s tax payments are "risky." In other words, one of the economic consequences

managers need to consider in determining the firm's tax policies is the impact on firm risk. This

view leads to the conclusion that managers consider a trade-off of the benefit from increased

cash flows from reduced tax payments against the cost of increased firm risk. To provide

empirical evidence on this issue we estimate the relations between firm risk (the one year ahead

volatility of the firm’s stock return) and three measures of tax policy: (1) the level of tax

avoidance (the cash effective tax rate), (2) tax aggressiveness (the reserve for UTBs), and (3) tax

risk (the standard deviation of the annual Cash ETR).

5

Before conducting our main tests, we first examine how each of the three tax policy

characteristics is related to the others.5 As expected, we find that the Cash ETR is negatively

correlated with the UTB reserve, which suggests that firms that take aggressive tax positions pay

lower amounts of their pretax income in taxes. However, perhaps surprisingly, we find a positive

correlation between the Cash ETR and tax risk, and a negative correlation between the UTB

balance and tax risk. These results suggest that firms that take aggressive tax positions and are

able to reduce their tax payments experience relatively stable tax rates.

We also examine the characteristics of firms that have high levels of tax avoidance, tax

aggressiveness, or tax risk. We find substantial differences in firm characteristics between firms

that demonstrate high tax avoidance or tax aggressiveness and firms that have high levels of tax

risk. Together, these results suggest that although the three concepts, or measures, are related,

they seem to capture different aspects of a firm’s tax policies.

In our main tests we regress future stock return volatility against each of our tax policy

measures. As discussed by Neuman et al. (2013), tax risk is an ex ante concept, and reflects

expected uncertainty about future events, so our measure of firm risk captures future volatility.

Our tests control for factors that prior research has linked to future stock return volatility,

including the historical variance of pretax earnings. We find that our measure of tax risk—the

standard deviation of the annual Cash ETR, measured over a five-year period—is positively

related to future stock return volatility. This result holds for both the full sample and the more

limited UTB sample, and is consistent with tax risk increasing the uncertainty of after-tax cash

flows. On the other hand, we do not find significant associations between future stock return

volatility and either the level of Cash ETR or the level of the UTB reserve. These results suggest

5 Because the UTB reserve is not available until 2007 or 2008, we conduct our tests on two samples. For tests that

do not require UTB data we use the full sample from 1987 – 2011. Tests that include the UTB reserve are conducted

on a more limited sample for which UTB data are available.

6

that tax avoidance and tax aggressiveness do not increase overall firm risk, and suggest that such

activities may not be “risky” in the traditional sense of that term.6,

7

We also investigate possible reasons why firm risk appears to be unrelated to either tax

avoidance or tax aggressiveness. One reason may be that these tax policies are only related to

firm risk when firms use the policies to unusually high degrees. To test this explanation, we

define indicator variables for each of our tax policy measures that identify observations in the

lowest quintile of Cash ETR or highest quintile of the UTB reserve or standard deviation of the

Cash ETR. Results using these extreme values are similar to our initial results in that firms with

high tax risk (i.e., high standard deviation of Cash ETR) have significantly higher firm risk, but

firms with high tax avoidance or tax aggressiveness do not have higher firm risk.

Our study makes several contributions to the literature on accounting for income taxes.

First, we clarify the underlying concepts reflected in different tax policies by differentiating the

concepts of tax avoidance, tax aggressiveness, and tax risk and suggesting appropriate empirical

measures to capture each type of tax policy. We also document systematic differences between

the characteristics of firms that display differences in tax avoidance, tax aggressiveness and tax

risk, which helps provide insight into which types of tax policies are captured by each measure.

Our results also highlight the importance of carefully considering which empirical measure best

reflects the underlying construct being studied.

We also provide evidence regarding the impact of different tax policies on firm risk. A

number of recent studies examining the determinants and economic implications of tax policies

6 If low Cash ETRs proxy for risky tax positions, we expect this risk to be reflected in stock returns in a future year

when additional tax and penalties are paid. For consistency, we use the same twelve-month period to measure stock

return volatility for all three of our tax aggressiveness measures. 7 In a concurrent paper, Hutchins and Rego (2012) document a significantly positive relation between the UTB

reserve and concurrent stock volatility. However, their empirical model does not include many of the control

variables from our study that prior research in finance has documented to be related to stock volatility.

7

have implicitly or explicitly assumed that tax avoidance and/or tax aggressiveness are risky

activities. We do not find evidence that investments in tax avoidance, as measured by the Cash

ETR, or tax aggressive policies, as measured by the UTB reserve, increase the firm’s overall

risk. In contrast, we document evidence that uncertainty with regard to the firm’s Cash ETR, as

measured by the standard deviation of the Cash ETR, is positively associated with firm risk. Our

results are consistent with the notion that when the volatility of cash ETR is high, investors have

more uncertainty regarding the tax rate applicable to the firm’s pretax cash flows. As information

is released that resolves that uncertainty, the stock price adjusts, thereby increasing stock return

volatility. Overall, our results suggest that tax policies that reduce the firm’s tax payments, or

increase the firm’s UTB reserve, only increase the risk of the firm if they increase uncertainty

regarding the firm’s tax future tax payments, suggesting that the firm is unable to sustain those

positions over time.

2. Tax Policies and Firm Risk

A key concept regarding a firm’s tax policies is tax avoidance, which represents the

ability of the firm to reduce its current tax payments. Tax avoidance is generally measured as the

ratio of taxes paid during the year to pretax financial reporting income: the Cash ETR. The

measure can be calculated on an annual basis, although Dyreng et al. (2008) recommend using

the sum of taxes paid over a five-year period and the sum of pretax income over the same period

to provide a better picture of the firm’s tax policies. Studies such as Brown, Drake, and Martin

(2013), Rego and Wilson (2012), Boivie et al (2012), and Higgins, Omer and Phillips (2012)

suggest that aggressive tax planning is a risky activity. They argue that firms lower their tax

payments by taking tax positions that have a relatively high probability of being disallowed.

8

Thus, although investments and policies that reduce the firm’s tax payments have a positive

expected value, the possibility that the firm’s tax positions will be challenged by the I.R.S. and

overturned by the courts makes these tax policies risky. Therefore, to encourage managers to

take risky tax positions with a positive expected value, the compensation committee increases the

reliance on stock options in executive compensation packages. This is consistent with the results

in Rego and Wilson (2012), who document a negative relation between the CEO’s risk-taking

incentives (the vega of their equity portfolio) and the level of a firm’s cash ETR.8

However, it is not clear that investments that generate lower tax payments will lead to

more volatile future cash flows and stock returns. Multinational companies generate a substantial

amount of their income in countries with low tax rates. As long as these companies reinvest their

operating earnings outside of the U.S., the corporation will continue to avoid the higher U.S. tax.

If a firm maintains a low, stable tax rate it is unlikely that the firm’s tax policies induce volatility

in the firm’s cash flows or stock returns. As an example, Panel A of Appendix A presents the

Cash ETR and volatility of Cash ETR for IBM from 2003 to 2007. IBM was consistently able to

pay a relatively low amount of taxes with a Cash ETR of 16.10%. The standard deviation of the

annual Cash ETR over this period was a relatively low 0.11. Thus, while the tax policies of IBM

appear to have lowered the taxes paid, the company was able to maintain that low rate fairly

consistently over the five-year period.

A second characteristic of tax policies is tax aggressiveness, or the extent to which firms

use ambiguity in the tax law to reduce their tax payments. For example, a firm may decide that

there is no clear authority on the tax treatment applicable to a specific transaction and assesses

the probability that a favorable interpretation has a 10% chance of being supported based on its

8 Armstrong, Blouin, and Larcker (2012) do not find a significant relation between the reliance on incentive-based

compensation (compensation mix) for the CEO and the firm’s Cash ETR. Thus, their evidence suggests that the

provision of stronger incentives to the CEO does not affect the firm’s tax policies.

9

technical merits. A tax aggressive firm would choose the favorable interpretation in preparing its

tax return, thereby reducing its current tax payments. We argue that the appropriate measure for

tax aggressiveness is the firm’s UTB reserve. FIN 48 requires firms to establish a reserve for a

tax position if it is more likely than not that the position will not be upheld based on its technical

merits. Thus, by definition, the UTB reserve should reflect the extent to which firms take tax

positions that are “aggressive” in the sense that they may not be in accordance with the tax law.

As an example, in its 2012 10-K Microsoft reported a UTB reserve of $7.2 billion and noted that

“the primary unresolved issue relates to transfer pricing, which could have a significant impact

on our financial statements if not resolved favorably.”

Taking aggressive tax positions can be considered a risky activity since it is likely that

their positions will be overturned in the future and the firm could have to repay the tax plus

interest and penalties. However, the impact of aggressive tax policies on overall firm risk is not

clear. First, the determination of whether a given tax position should be included in the reserve

requires subjective judgment. As a result, different firms taking the same tax positions are likely

to have different UTB reserves. Second, the time period in which the tax positions will be

resolved is not clear. Microsoft states that “we do not believe the remaining open issues will be

resolved within the next 12 months.” Thus, the impact of aggressive tax positions on the firm’s

tax payments could be delayed for an indefinite period of time. In fact, because Fin 48 specifies

that firms ignore the probability of audit, it is possible that the amounts in the UTB reserve will

never be paid. Finally, if firms consistently take aggressive tax positions, unfavorable resolutions

of prior aggressive tax positions could be offset by new aggressive tax positions, leaving the

firm’s total tax payments relatively constant over time.

10

The third characteristic of tax policies we consider is tax risk, which we define as

uncertainty about the firm’s tax rate. We measure tax risk as the standard deviation of a firm’s

Cash ETR, which captures the volatility of the Cash ETR.9 Our measure of tax risk essentially

measures the extent to which a firm is able to sustain its tax positions over time.

As an example, consider the case of DPL Incorporated, detailed in Panel B of Appendix

A. Over the 2002-2006 period the standard deviation of the company’s cash ETR is 0.23, which

places it in the top quintile of the distribution. . DPL’s annual cash ETR dropped from 75.58% in

2002 to 6.03% in 2003, and rose to 31.47% in 2004. The volatility in the Cash ETR for DPL

suggests the company was unable to sustain the tax positions that lowered the Cash ETR in 2003.

As a result, at the end of 2006, there is uncertainty whether the firm will pay a tax rate close to

the 42.64% paid in 2006, drop to the 26.79% paid in 2005, or rise back to the 75.58% paid in

2002. Therefore, after forecasting pretax income, investors face additional uncertainty in

determining the appropriate tax rate to use to forecast after-tax cash flows. While in the case of

IBM, information released in the subsequent year regarding IBM’s actual tax rate is likely to

have a relatively small effect on IBM’s after-tax cash flows and share price, information

regarding whether DPL will be paying 75.58 percent of its pretax income or 6 percent of its

pretax income in taxes will have a relatively large effect on after-tax cash flows and thereby lead

to a higher volatility in stock returns.

While it may seem obvious that uncertainty about a firm's tax rate will affect overall firm

risk, we believe there are two reasons why the relation between tax risk and firm risk is an

empirical question. First, to the best of our knowledge there is no prior empirical evidence that

uncertainty regarding a firm’s tax rate leads to uncertainty with regard to the firm’s after-tax cash

9 As we discuss below, we also conduct a sensitivity test using the coefficient of variation of the Cash ETR, which

scales the standard deviation by the mean. Our results are similar with either measure of volatility.

11

flows. Second, despite publications by practitioners stating that tax risk is a component of firm

risk, it may be the case that investors do not consider corporate taxes when making investment

decisions, and in that case stock return volatility would be unrelated to tax rate volatility.

In a concurrent paper, Hutchins and Rego (2012) examine how different measures of tax

risk relate to the firm’s cost of capital. The cost of capital can be interpreted as a measure of the

risk perceived by shareholders. However, the theoretical link between tax risk and the firm’s cost

of capital is not clear, since tax risk is a type of idiosyncratic risk which investors can avoid by

diversification. In addition, empirical measures of cost of capital relate current stock price to

analysts' earnings forecasts. This is problematic because the UTB reserve, a measure of tax risk,

reflects tax benefits that have, by definition, not been recorded in the firm's earnings. In other

words, if the risky uncertain tax benefits are not reflected in the analysts' forecast of earnings, it

isn't clear why a higher discount rate should be applied to those forecasted earnings to arrive at a

stock price. In contrast, the measure of firm risk we use in this paper, stock return volatility, is a

more direct, albeit ex post, measure of the underlying uncertainty regarding the firm’s after-tax

cash flows.10

Stock return volatility also has a direct influence on the value of risk incentives in

that option-pricing models show that the value of a stock option increases with stock return

volatility.

3. Empirical Tests

3.1 Sample Selection and Key Variable Definitions

Our sample begins with all observations on the CRSP/Compustat merged database from

1987 to 2011 with data necessary to compute our regression variables. We start with 1987

10

In other words, a firm with volatile after-tax cash flows will have volatile stock returns, regardless of the effect of

tax risk on cost of capital.

12

because this is the first year that many of the data items necessary to compute our variables of

interest, such as cash taxes paid, are available on Compustat. To reduce the impact of different

legal systems, including tax laws and enforcement, we drop firms that are not incorporated in the

U. S. To allow a meaningful interpretation of the Cash ETR we require firms to have positive

pre-tax income (Dyreng, et al. 2008). In addition, each firm must have sufficient data for five

consecutive years to calculate the Cash ETR, and data for a sixth consecutive year to calculate

stock return volatility. Finally, we require firms to have stock return data for all 12 months of the

year on the CRSP database. This procedure yields a total of 16,547 firm-year observations.

Table 1 shows the number of times each unique firm appears in our sample. Because we

use firm fixed effects in our analyses utilizing our full sample, we require each firm to appear at

least twice in our sample. Our sample includes of 2,376 unique firms, with 388 firms appearing

twice and a total of 69 firms appearing the maximum of 19 or 20 years.11

The vast majority of

firms in our sample are not present throughout the entire sample period, due to both sample

changes (firms that exit before the end of the sample period or enter after the beginning of the

sample period), and the requirement that the firm have positive pre-tax income for five

consecutive years. To control for the fact that we have multiple and unequal numbers of

observations per firm and per year in our sample, we include both firm and year fixed effects in

the regressions.

Following Dyreng et al. (2008), we calculate our measure of tax avoidance (Cash ETR)

as the ratio of the sum of the cash tax payments over a five-year period to the sum of income

before taxes and special items over the same five-year period. To calculate tax risk (Tax Risk),

we compute the annual Cash ETR (cash taxes paid for the year scaled by income before taxes

11

Because fiscal years do not match up exactly with calendar years, some of our firms have a maximum of 20 years

of reported data, while others only have 19 years.

13

and special items for the year) over each of the five years in the sample period and calculate the

standard deviation of the five annual Cash ETRs. We use a rolling five-year window to calculate

each measure and include a firm if it has sufficient data for the five-year period to construct the

tax aggressiveness measures and sufficient data to calculate the subsequent year’s stock return

volatility. Examples of the calculation of the Cash ETR and standard deviation of the Cash ETR

can be found in Appendix A.

Our measure of tax aggressiveness is the FIN 48 UTB reserve scaled by lagged total

assets. Because the UTB reserve is only available for a limited set of firms for a few years (2007-

2011), the sample for tests that require the UTB reserve is limited to the 1,960 firm-years for

which the UTB data are available. In addition, because firms can only be included in the sample

for a maximum of 4 years, we replace the firm fixed effects with industry fixed effects in tests on

the UTB sample.

The dependent variable in our analysis is the volatility of stock returns (StdDev_Return).

To compute the volatility we use the standard deviation of the twelve monthly returns in the

fiscal year immediately following the last of the five years used in our tax measures.

3.2 Research Design

To examine the association between tax policies and firm risk, we separately regress the

subsequent year stock return volatility on each tax policy measure and a common set of control

variables derived from prior research.

SD_Retit+1 = 0 + 1TAXit + 2PTBIt + 3Vol_of_PTBIit + 4BTMit

+5Leverageit +6Sizeit + 7Abn_Accrualsit + 8Returnit+1 +

+ 9Shares_Outit + 10Inst_Ownit1 + it (1)

14

To calculate our variables we use the following formulas (Compustat Variable Name):

SD_Ret = standard deviation of monthly stock returns;

TAX = either Cash ETR, Tax Risk, or UTB, where Cash ETR is the five year sum

(measured from year t-4 to year t) of cash taxes paid (TXPD) divided by the

five-year sum of pre-tax income (PI) less special items (SPI). Tax Risk is the

standard deviation of annual Cash ETRs over the previous 5 years, or UTB,

calculated as the balance of the unrecognized tax benefits (TXTUBEND)

scaled by lagged total assets (AT);12

PTBI = pretax book income (PTBI) scaled by lagged total assets;

Vol_of_PTBI = standard deviation of the ratio of annual pretax income (PI) to lagged total

assets (AT) measured over a five-year period;

BTM = year-end book value of equity (CEQ) over the price per share (PRCC_F)

times the total number of shares outstanding (CSHO);

Leverage = year-end long-term debt (DLTT) scaled by lagged total assets;

Size = natural log of total assets (AT);

Abn_Accrual = square of year-end discretionary accruals, estimated using the modified Jones

model from Dechow et al. (1995);

Return = firm’s annual buy and hold stock return measured over the fiscal year;

Shares Out = log of the firms common shares outstanding (CSHO); and

Inst Own = firm’s average institutional ownership measured over the fiscal year.

As noted above, we use the standard deviation of returns rather than systematic risk (i.e.,

beta) because we are interested in the impact of tax policies on the overall risk of the firm, as

12

To have a meaningful interpretation of the Cash ETR we require positive pretax income and we winsorize the

Cash ETR at 0 and 1 (following Dyreng et al 2008).

15

reflected in the riskiness of the firm’s cash flows. We use pretax income from operations to

control for the firm’s operating performance, which has been shown to be negatively associated

with stock return volatility (Hanlon et al. 2004). The volatility of pretax income measured over

the same period as the tax rate variables controls for the riskiness of the firm’s operations.13

The

book-to-market variable controls for the extent of the firm’s growth opportunities, which we

expect to be positively associated with stock return volatility. We include financial leverage to

control for the additional risk imposed by financial distress and capital constraints (Rajgopal and

Venkatachalam 2011). We control for size since smaller firms experience greater return volatility

(Pastor and Veronesi 2003). The extent of discretionary accruals controls for the risk associated

with lower earnings quality (Rajgopal and Venkatachalam 2011). We also control for the firm’s

stock return over the current year, as stock return is negatively related to return volatility (Duffie

1995). To control for stock trading differences due to investor composition, we include the firm’s

average institutional ownership over the year (Bushee and Noe 2000). Finally, we include the

number of shares outstanding in the current year, as the supply of a firm’s shares has been shown

to be a significant determinant of stock return volatility (Cohen, Ness, Okuda, Schwartz and

Whitcomb 1975).

Our regression specification also includes firm and year fixed effects for the full sample

and industry and year fixed effects for the UTB sample. A Hausman test between fixed and

random effects indicates that OLS is not consistent and that fixed effects are appropriate. As

noted above, we have a substantial number of firms included in the sample multiple times. By

including firm fixed effects the regression explains deviations from the average return volatility

for each firm and therefore reduces potential problems associated with firm-specific omitted

13

In unreported sensitivity tests we use the standard deviation of cash flows from operations and sales instead of

pretax income to control for the riskiness of the firm’s operations. Inferences are unchanged.

16

variables that are correlated with the firm’s average stock return volatility.14

The year fixed

effect controls for differences in tax laws and other macroeconomic effects across time.

3.3 Descriptive Statistics

Table 2 presents descriptive statistics for the dependent and independent variables used in

the regressions. The mean (median) Cash ETR of 28.9% (30%) is similar to the levels reported in

prior research. The distribution of the standard deviation of Cash ETR appears to be positively

skewed with a mean of 11.6% and median of 7.7%.

Table 3 provides data regarding the correlations between our tax policy measures. The

data reported in Panels A and C include observations for the restricted sample for which UTB

data are available. The data in Panel B are based on the full sample. The pairwise correlation

coefficients presented in Panel A indicate a strong positive correlation between the level of Cash

ETR and tax risk. Because a low Cash ETR is indicative of a high degree of tax avoidance, this

suggests that firms that avoid taxes pay a fairly stable proportion of pretax income in taxes.

Similarly, we find significantly negative correlations between the Cash ETR and UTB reserve,

which is consistent with firms that avoid tax taking more aggressive tax positions. However, the

relation between tax risk and tax aggressiveness is less clear. Although the Pearson correlation

coefficient is significantly negative, it is small (-0.090) and the Spearman Rank correlation

coefficient is not significant (-0.002).

To further illustrate the relationships among tax avoidance, tax aggressiveness and tax

risk we compare the number of observations in common quintiles. Panel B of Table 1 compares

tax avoidance and tax risk. As there are 25 possible combinations, the expected number of

14

In our tests using the UTB sample, we re-estimate these regressions using industry (two-digit SIC code) effects

instead of firm effects and find similar results.

17

observations in each cell is approximately 667, or 1/25 of the total of 16,686. Consistent with the

positive correlation, we find that firms with extremely low tax rates tend to have low risk. A total

of 871 observations fall in the lowest quintile of both Cash ETR and standard deviation of Cash

ETR. Similarly, firms that have high levels of tax risk tend to have high Cash ETRs. A total of

1,183 observations are in the high tax rate, high tax risk quintile combination.

These results suggest that tax policies that reduce the amount of taxes paid do not

increase the volatility of the firm’s tax payments. To a certain extent, this is mechanical given

that the Cash ETRs are computed over a five-year period, i.e., firms in the lowest Cash ETR

quintile probably didn’t pay a high amount of taxes in any of the five years. However, we also

note that although the highest concentration of observations from the low Cash ETR quintile row

is in the lowest Cash ETR column, there are at least 500 observations in each cell in the row.

The relation between tax aggressiveness and tax risk (Panel C of Table 3) is less clear.

Because UTB data are only available after 2007, the number of observations declines to 1,960

leading to expected value of 78 observations in each cell (assuming random distribution). The 82

observations in the high UTB, high tax risk cell is only slightly higher than the 78 observations

based on random assignment. The cell with the highest number of observations (107) includes

firms that are in the lowest UTB quintile and highest volatility quintile. Thus, the evidence does

not appear to suggest that firms that take aggressive tax positions (as measured by the UTB

reserve) experience volatile tax payments.

To provide more evidence on the stability of low tax rates, we estimate separate logit

regressions with the dependent variable equal to one if the firm is in the lowest (highest) quintile

of Cash ETR, and zero otherwise. In each regression the variable of interest is equal to one if the

firm was in the lowest (highest) Cash ETR quintile in the latest non-overlapping five-year

18

period, and zero otherwise. The regressions also include year dummy variables. The coefficient

on the lagged indicator variable can be used to assess the persistence of the firm’s tax rate. We

present the results in Panel D of Table 3. In Column (1) the coefficient on the lagged Cash ETR

quintile variable of 2.346 indicates that a firm that is in the lowest Cash ETR is 10 times (e2.346

)

more likely to be in the lowest Cash ETR quintile computed over the next five-year (non-

overlapping) period than firms that are not in the lowest quintile. In contrast, the coefficient on

the lagged indicator variable for the highest Cash ETR quintile of 1.211 shown in Column (2)

indicates that a firm in the highest Cash ETR quintile is only 3 times (e1.211

) more likely to

remain in the highest Cash ETR quintile. These results suggest that low tax rates are more

persistent than high tax rates, and that firms who are able to lower their tax payments are often

able to sustain those positions over a long period of time.

Panel D of Table 3 presents the Pearson and Spearman pairwise correlations for the full

sample. There appear to be significant correlations between the volatility of stock returns and

each of our control variables, with the strongest correlations with the volatility of pretax income

and size. Tax avoidance seems to be most highly correlated with size, institutional ownership and

the number of outstanding shares, where tax risk appears to be most highly correlated with pretax

income, the book to market ratio, and shares outstanding.

3.4 The Determinants of Tax Avoidance, Tax Aggressiveness and Tax Risk

To provide insight into the factors that generate high tax avoidance, tax aggressiveness or

tax risk, we regress the incidence of being in the lowest Cash ETR quintile, highest UTB reserve

quintile, or highest standard deviation of Cash ETR quintile, on firm characteristics that are

likely to affect the firm’s tax payments. For consistent comparisons across regressions we

19

conduct this test using only our sample of firm-year observations that also have data available for

UTBs. Specifically, we estimate the following logit regression:15

Tax_Quintileit = 0 + 1Sizeit + 2PPEit + 3Foreign_Salesit + 4R&Dit + 5Intang_Assetsit

+ 6ESO_Benefitit + 7Leverageit + it (2)

Where:

Tax_Quintile = alternately, High Tax Avoidance, which is equal to one if the observation is in

the lowest Cash ETR quintile and zero otherwise, High Tax Aggressiveness,

which is equal to one if the observation is in the highest quintile of

Unrecognized Tax Benefits and zero otherwise, or High Tax Risk, which is

equal to one if the observation is in the highest standard deviation of Cash

ETR quintile, and zero otherwise;

PPE = net property plant and equipment (PPENT) scaled by lagged total assets;

Foreign_Sales = foreign sales (foreign sales from geographic segments) divided by total sales

(sale), where foreign sales is set to 0 if missing;

R&D = research and development expense (XRD) scaled by lagged total assets;

Intang Assets = intangible Assets (INTAN) scaled by lagged total assets;

ESO_Benefit = the excess tax benefit of stock options (TXBCOF) scaled by lagged total

assets, and other variables are as previously defined; and

Leverage = year-end long-term debt (DLTT) scaled by lagged total assets.

We include size to capture the firm’s investment in tax savings. To the extent there are

economies of scale in tax investments, larger firms are able to invest more in tax departments to

find tax savings. The relative investment in net property, plant, and equipment is included to

15

Detailed variable definitions for the Logit Prediction Model can also be found in Appendix B.

20

capture the value of the depreciation tax shield. Because tax rates in foreign jurisdictions are

often lower than domestic rates, we include foreign sales. We include research and development

expenditures to capture the various tax credits that are available for research activities. We

include intangible assets because these assets are easier to transfer between operating units and

have therefore been associated with income shifting (either between countries or between states)

to lower tax payments. The excess tax benefit from stock option exercises affects tax rates

because the amount of the tax deduction is based the ex post gain on exercise, while the amount

of the option expense is based on the ex-ante value of the stock option. Finally, we include

leverage to capture the debt tax shield. We conduct our tests on the limited sample for which

UTB data are available, include year fixed effects and cluster standard errors by firm.

The results of estimating equation (2) are presented in Table 4. Column (1) indicates that

firms that display high tax avoidance (low Cash ETRs) have significantly higher investments in

property, plant, and equipment, have higher levels of research and development, greater tax

benefit from the exercise of options by employees and higher financial leverage. These results

are consistent with firms using tax shields to reduce their tax payments. The greater tax benefit

from the exercise of stock options is consistent with the Rego and Wilson (2012) finding that

firms that avoid taxes tend to utilize more stock options. However, attributing the relation to the

need to provide risk-taking incentives to encourage tax avoidance assumes that tax avoidance

activities increase firm risk.

The results in column (2) of Table 4 show that tax aggressive firms (high UTB reserves)

are significantly larger, have lower investments in PPE, a greater proportion of foreign sales and

higher R&D expenditures. The positive relation with size is consistent with larger firms investing

greater resources into taking aggressive tax positions. The negative coefficient on property, plant

21

and equipment, combined with the positive coefficients on foreign income and R&D

expenditures are consistent with tax aggressive firms utilizing foreign subsidiaries to reduce their

tax payments.16

Unlike high tax avoidance firms, firms that display high tax aggressiveness do

not have significantly higher tax benefits from employee stock option exercises or greater

degrees of leverage than non-tax aggressive firms.

The results reported in column (3) of Table 4 indicate that firms that display high tax risk

tend to be smaller than the average firm. This is consistent with smaller firms not having the

resources to invest in devising sustainable tax policies. High tax risk firms also have lower

investments in intangible assets, lower tax benefit from stock options, and higher leverage than

average firms.

Overall, Table 4 documents that there are a large number of differences in the

characteristics of firms that have high tax avoidance, aggressiveness and risk. Specifically, while

firms with high tax avoidance are able to take advantage of the tax shields associated with

accelerated depreciation, research and development expenditures, employee stock option

exercises and interest payments, high tax aggressive firms are larger firms that generate a higher

degree of foreign sales, have lower investments in property, plant and equipment, and higher

investments in research and development. In contrast, firms that have volatile Cash ETRs tend to

be smaller firms with fewer intangible assets, fewer employee stock option exercises and a

higher degree of leverage than the average firm.

16

Because it is easier to transfer intangible assets than physical assets, firms often use intangible assets to transfer

income to low tax jurisdictions. The positive coefficient on R&D and the insignificant coefficient on intangible

assets suggest that tax aggressive firms are more likely to use internally generated intangible assets to shift income.

22

3.5 Regression Analysis

To test whether tax avoidance, tax aggressiveness or tax risk is associated with firm risk,

we estimate regression equation (1) for each tax policy measure and report the results in Table 5.

Panel A of Table 5 presents the results for the full sample. In each regression, the dependent

variable is the one-year ahead stock return volatility measured as the standard deviation of

twelve monthly stock returns. In columns 1 and 2 we report the results for tax avoidance and tax

risk without the control variables. These results differ from the pairwise correlations because

they include both year and firm fixed effects. We find an insignificant coefficient for the Cash

ETR (column 1) and a significantly positive coefficient on tax risk (column 2). We find similar

results in Columns 3 and 4 when we include the control variables. The insignificant relations for

the Cash ETR raise questions as to whether tax avoidance, per se, is a risky activity. The

significantly positive coefficient for the standard deviation of the annual cash ETR suggests that

tax avoidance is only a risky activity if the firm is unable to sustain its tax positions over time.

Our results also suggest that the degree of uncertainty regarding the firm’s tax rate is associated

with the riskiness of the firm’s after-tax cash flows.

The results for the control variables are generally significant in the expected directions.

The exceptions are insignificant relations for our measures for expected growth (book to market),

and accounting quality (abnormal accruals), and significantly positive relations for firm

performance (stock return and pretax book income). The insignificant results could be attributed

to their effect being reflected in the other independent variables. The positive relation between

performance and future volatility could be due to the composition of our sample. We require

firms to have six consecutive years of data and five consecutive years of positive pretax book

income. As a result, firms in financial distress, which are generally responsible for the negative

23

relation between performance and volatility, are excluded from our sample.

Panel B of Table 5 reports the results from the estimation of equation (1) on the limited

sample with UTB data. In Columns 1-3 we present the results without control variables and in

Columns 4–6 we present the results after including the control variables. Because the limited

time period reduces the number of observations per firm, we replace the firm fixed effects used

in the full sample regressions with industry fixed effects. We retain year fixed effects. We find

insignificant coefficients for the level of the Cash ETR (columns 1 and 4) and the UTB reserve

(columns 2 and 5). Thus, we do not find evidence that tax avoidance or tax aggressiveness

increases the riskiness of the firm’s cash flows. On the other hand, we continue to find a positive

relation between tax risk and stock return volatility.

Overall, our results suggest that uncertainty regarding the firm’s tax rate, as reflected in

the standard deviation of the firm’s annual Cash ETR, increases uncertainty regarding the firm’s

cash flows, as reflected in the volatility of the firm’s stock return. Tax policies that reduce the

firm’s tax payments or increase the firm’s UTB reserve only increase firm risk if they also

increase the volatility of the firm’s tax payments. Tax policies, whether aggressive or not, that

lead to relatively stable tax payments over time do not appear to increase firm risk.

The regression results reported in Table 5 assume a linear relation between the tax

measures and stock return volatility. However, it is possible that the impact on firm risk is

concentrated in extreme tax policies. In other words, while there may be relatively weak overall

relations between tax avoidance, or tax aggressiveness, and firm risk, unusually large degrees of

tax avoidance or aggressiveness could be still lead to a high degree of volatility. This effect

could be obscured by the inclusion of firms for which the relation is small, or nonexistent. To

provide evidence on this question we define indicator variables that are set equal to one if the

24

firm is in either the lowest quintile of Cash ETR, the highest quintile of the UTB reserve, or the

highest standard deviation of Cash ETR quintile. We then replace the continuous tax variables

with the indicator variables in estimating equation (1).

Table 6 reports the results using the indicator variables for extreme quintiles. Panel A of

Table 6 presents the results for the full sample and Panel B of Table 6 presents the results for the

limited UTB sample. In both samples, the coefficients for the high tax avoidance and high tax

aggressiveness indicator variables are not significant. Thus we do not find evidence that

displaying an unusually high degree of tax avoidance or tax aggressiveness increases firm risk.

The coefficients for the high tax risk indicator variable remain significantly positive. This is

consistent with unusually high tax risk leading to higher firm risk.

Finally, we consider the coefficient of variation of the Cash ETR as an alternative

measure of tax risk. The coefficient of variation scales the standard deviation by the mean of the

Cash ETR. Thus, the coefficient of variation considers volatility relative to the mean, or converts

raw differences to percentage differences. For example, consider a firm that has a mean Cash

ETR of 15% and a firm that has a mean Cash ETR of 35% and assume that both firms receive a

shock that increases the mean by 5% of pretax book income, i.e., to 20% and 40%. The standard

deviation of the Cash ETR would treat the shock equally for both firms, i.e., going from 15% to

20% is equivalent to going from 35% to 40%. However the coefficient of variation would

consider the shock to be greater for the low Cash ETR firm because the 5% increase is a greater

percentage increase for the low Cash ETR firm.

Panels A, B, and C of Table 7 present the correlations between the coefficient of

variation of Cash ETR, the level of the Cash ETR and UTB reserves. Not surprisingly, dividing

the standard deviation by the mean generates a negative correlation between the coefficient of

25

variation and the level of the Cash ETR. Whether this induces or removes a bias in the volatility

measure depends on whether the underlying uncertainty in the firm’s tax rate is best captured by

variation in the tax rate or the percentage variation in the tax rate.

To assess whether the relation between tax risk and firm risk is sensitive to the measure

of tax risk, we replace the standard deviation of the Cash ETR with the coefficient of variation of

the Cash ETR and estimate equation (1). The results presented in Panel D of Table 7 indicate a

significantly positive relation between the coefficient of variation of the Cash ETR and future

stock price volatility. Thus, the conclusion that uncertainty regarding the firm’s tax rate increases

overall firm risk is unchanged.

4. Conclusion

We consider different characteristics of a firm’s tax policies and examine whether they

are associated with future firm risk. Our paper is motivated by the recent appearance of research

papers that assume that tax avoidance or tax aggressiveness increases the risk of the firm. We

define three different tax concepts and specify empirical measures for each concept. Tax

avoidance represents the ability of the firm to reduce its tax payments and is measured by the

cash effective tax rate. Tax aggressiveness represents the extent to which the firm takes tax

positions that are unlikely to be supported by the tax authorities and is measured by the reserve

for unrecognized tax benefits, scaled by lagged total assets. Tax risk represents the ability of the

firm to sustain its tax positions over time, and is measured by the standard deviation of the

annual cash effective tax rates.

We first compare the three tax policy measures, and do not find evidence that high tax

avoidance, or high tax aggressiveness is associated with high tax risk. Firms that follow tax

26

policies that lower their tax payments are able to sustain their tax positions over time and high

reserves for uncertain tax benefits are not associated with volatile tax rates. We also find that

each tax concept appears to have differential relations with underlying firm characteristics.

In our main tests we examine whether the extent of a firm’s tax avoidance, tax

aggressiveness or tax risk is associated with firm risk. Our results indicate that tax risk is

positively associated with overall firm risk, as measured by the one-year ahead standard

deviation of monthly stock returns. However, we do not find evidence of a significant relation

between future stock return volatility and either tax avoidance or tax aggressiveness. Our results

suggest that tax policies only increase the risk of the firm if they increase the uncertainty

regarding the firm’s tax payments.

The results of our study make important contributions to tax research. First, our evidence

suggests that a low cash tax rate is not associated with higher risk, as measured by future stock

return volatility. This has implications for interpreting the results of prior studies that suggest

that activities that reduce the firm’s tax payments increase the firm’s risk. Second, our evidence

supports the standard deviation of the annual Cash ETR as a measure of tax risk and suggests

that tax risk is an important component of overall firm risk. Finally, our results suggest that the

level of Cash ETR, UTB reserve and the standard deviation of Cash ETR reflect different types

of tax policies.

27

References

Armstrong, C., J. Blouin and D. Larcker. 2012. The incentives for tax planning. Journal of

Accounting and Economics 53: 391-411.

Brealey, R. and S. Myers. 1991. Principles of Corporate Finance Fourth Edition. McGraw-Hill,

Inc. New York.

Brown, J., K. Drake and M. Martin. 2013. Are firms myopic? The case of contracting on

performance and uncertainty. Working paper. Arizona State University.

Bushee, B. and C. Noe,. 2000. Corporate Disclosure Practices, Institutional Investors and Stock

Return Volatility. Journal of Accounting Research, Vol 38 Supplement. 171-202

Campbell, J., H. Chen, D. Dhaliwal, H. Lu, and L. Steele. 2013. The Information Content of

Mandatory Risk Factor Disclosures in Corporate Filings. Forthcoming in Review of

Accounting Studies

Cassel, C., S. Huang, J. Sancez, and M. Stuart. 2012. Seeking safety: The relation between CEO

inside debt holdings and the riskiness of firm investment and financial policies. Journal

of Financial Economics 103: 588-610.

Boivie, S., Christensen, D., Dhaliwal, D., Graffin, Scott, D. 2012. Managers' personal political

orientation and corporate tax avoidance. Working paper. University of Arizona.

Cochrane, J. 2001. Asset Pricing. Princeton University Press. Princeton New Jersey.

Cohen, K., W. Ness, H. Okuda, R. Schwartz, and D. Whitcomb. 1975. The Determinants of

Stock Return Volatility: An International Comparison. Journal of Finance XXI: 733-740.

Dechow, P., R. Soan and A. Sweeney. 1996. Detecting Earnings Management. 1993-225. The

Accounting Review 70: 193-225.

28

Dyreng, S., M. Hanlon and E. Maydew. 2008. Long run corporate tax avoidance. The Accounting

Review 83: 61-82.

Duffie, G. 1995. Stock Return and volatilty: a firm-level analysis. Journal of Financial

Economics 37: 399-420.

Ernst & Young. 2011. 2011-12 Tax risk and controversy survey. Available at:

http://www.ey.com/GL/en/Services/Tax/2011-12-Tax-risk-and-controversy-survey.

Fama, E. 1976. Foundations of Finance: Portfolio Decisions and Securities Prices. Basic Books,

New York.

Hanlon, M., S. Rajgopal and T. Shevlin. 2004. Large sample evidence on the relation between

stock options and risk taking. Working paper, University of Washington.

Higgins, D., T. Omer and J. Phillips. 2012. Tax avoidance versus aggressiveness: The influence

of a firm’s business strategy. Working paper, University of Connecticut.

Hutchins, M. and S. Rego. 2012. Tax Risk and the Cost of Equity Capital. Working paper,

Indiana University.

KPMG. 2011. Tax Governance Institute: Tax risk management e-survey. Available at:

http://www.kpmginstitutes.com/tax-governance-institute/insights/2011/pdf/tax-risk-

management-survey-report.pdf.

Lisowsky, P., L. Robinson and A. Schmidt. 2013. Do publicly disclosed tax reserves tell us about

privately disclosed tax shelter activity? Journal of Accounting Research 51: 583-629.

Markowitz, H. 1952. Portfolio selection. The Journal of Finance 7: 77-91.

McGuire, S., S. Neuman and T. Omer. 2013. Sustainable Tax Strategies and Earnings

Persistence. Working paper, Texas A&M University.

29

Neuman, S., T. Omer and A. Schmidt. 2013. Risk and return: does tax risk reduce firms'

effective tax rates? Working paper, Texas A&M University and North Carolina State

University.

Pastor, L., and P. Veronesi. 2003. Stock valuation and learning about profitability. Journal of

Finance 58: 1749-1789.

Pennacchi, G. 2007. Theory of Asset Pricing. Prentice Hall. New Jersey.

Powers, M. 2009. Rethinking risk and return: Part 1 – Novel norms for non-normality? Journal

of Risk Finance 10.

Pricewaterhouse Coopers. 2004. Tax risk management. Available at:

http://www.pwc.com/en_GX/gx/tax-management-strategy/pdf/tax-risk-management-

guide.pdf.

Rajgopal, S. and M. Venkatachalam. 2011. Financial Reporting Quality and Idiosyncratic Return

Volatility. Journal of Accounting and Economics 51: 1-20.

Rego, S., and R. Wilson. 2012. Equity Risk Incentives and Corporate Tax Aggressiveness.

Journal of Accounting Research 50: 775-809.

Robinson, J., Y. Xue, and M. Zhang. 2012. Tax planning and financial expertise in the audit

committee. Working paper.

30

Appendix A

Tax Rate Examples

Panel A: High Tax Avoidance (Low Cash ETR)

IBM

(Dollars in billions)

2003 2004 2005 2006 2007 Total

Pre-tax income before special items $10.883 $12.473 $12.378 $13.265 $14.441 $63.440

Cash taxes paid $1.707 $1.837 $1.994 $2.068 $2.608 $10.214

Cash ETR 16.10%

Annual Cash ETR 15.69% 14.73% 16.11% 15.59% 18.06%

Mean annual Cash ETR 16.03%

Standard deviation of Cash ETR 0.011

Coefficient of variation of Cash ETR 0.07

Panel B: High Tax Risk

DPL Incorporated

(Dollars in millions)

2002 2003 2004 2005 2006 Total

Pre-tax income before special items $137.6 $252.0 $342.9 $265.8 $266.4 $1264.7

Cash taxes paid $104 $15.2 $107.9 $71.2 $113.6 $411.9

Cash ETR 32.57%

Annual Cash ETR 75.58% 6.03% 31.47% 26.79% 42.64%

Mean Annual Cash ETR 36.60%

Standard deviation of Cash ETR 0.23

Coefficient of Variation of Cash ETR 0.63

31

APPENDIX B Variable Definitions

Full-Sample Analysis

SD_Ret = the standard deviation of monthly stock returns measured the subsequent

year.

Cash ETR = the 5 year sum (from year t-4 to year t) of cash taxes paid (TXPD) divided

by the 5-year sum of pre-tax income (PI) less special items (SPI). In order to

allow for meaningful interpretation firms are required to have a positive

denominator and Cash ETR is winsorized at 0 and 1.

Tax Risk = the standard deviation of one-year cash ETR over the time period t-4 to t.

One year Cash ETR is defined as cash taxes paid (TXPD) divided by pretax

income (PI) less special items (SPI).

UTB = unrecognized tax benefits (TXTUBEND) scaled by lagged total assets

(AT)

Size = natural log of total assets (AT)

PTBI = pretax book income (PI) scaled by lagged total assets (AT))

BTM = book value of equity (CEQ) over price per share (PRCC_F) times total

common shares outstanding (CSHO)

Leverage = long-term debt (DLTT) scaled by lagged total assets

Abn_Accruals = the square of discretionary accruals, where discretionary accruals are

estimated using the Modified-Jones method from Dechow et al (1995)

Vol_of_PTBI = standard deviation (measured over the previous five years) of the ratio of

pretax book income (PI) to lagged total assets (AT)

Return = the firm’s annual buy and hold stock return measured over year t+1.

Inst_Own = the firm’s average institutional ownership measured over the fiscal

year. Shares_Out = the log of the firms common shares outstanding (CSHO).

Logit Prediction Model

Size = natural log of total assets (AT)

PPE = Net Property Plant and Equipment (PPENT) scaled by lagged total

assets. PPE is set to 0 if missing.

Foreign_Sales = foreign sales (foreign sales from geographic segment data) over total

sales (sale), where foreign sales is set to 0 if missing.

R&D = Research and development expense (XRD) scaled by lagged total

assets. XRD is set to 0 if missing

Intang_Assets = intangible assets (INTAN) scaled by lagged assets.

ESO_Benefits = the excess tax benefit of stock options (TXBCOF) scaled by lagged

total assets. Stock Option Tax Benefit is set to 0 if missing.

Leverage = long-term debt (DLTT) scaled by lagged total assets

32

Table 1

Number of Observations per Firm

Number of Years Each

Firm Appears in the Sample

Number of

Firms

Number of

Observations

2 388 776

3 314 942

4 266 1064

5 191 955

6 178 1068

7 149 1043

8 124 992

9 113 1017

10 116 1160

11 116 1276

12 70 840

13 70 910

14 62 868

15 56 840

16 26 416

17 21 357

18 47 846

19 64 1216

20 5 100

All Years 2,376 16,686

This table provides data on the number of times each unique firm appears in our sample.

33

Table 2

Summary Statistics

Variable

N Mean

Standard

Deviation

25th

Percentile

50th

Percentile

75th

Percentile

Volatility of stock returns 16,686 0.098 0.048 0.063 0.088 0.121

Cash ETR 16,686 0.289 0.115 0.224 0.300 0.359

Cash ETR Volatility 16,686 0.116 0.144 0.047 0.077 0.126

PTBI 16,686 0.139 0.099 0.068 0.115 0.183

Volatility of PTBI 16,686 0.043 0.041 0.017 0.031 0.052

Book to Market 16,686 0.507 0.323 0.283 0.446 0.650

Leverage 16,686 0.194 0.188 0.014 0.163 0.305

Size 16,686 6.468 1.881 5.145 6.400 7.738

Abnormal accruals 16,686 0.124 0.596 0.000 0.003 0.016

Stock return 16,686 0.078 0.385 -0.166 0.039 0.258

Institutional ownership 16,686 0.452 0.272 0.236 0.429 0.667

Shares outstanding 16,686 3.444 1.503 2.366 3.374 4.393

This table presents the summary statistics for the variables included in the full sample tests. All variables are as

defined in Appendix B. All continuous variables are winsorized at the 1st and 99

th Percentiles.

34

Table 3

Pairwise Correlations of Tax Policy Measures

Panel A: Pairwise Correlations

Cash ETR UTB Tax Risk

Cash ETR 1.00 -0.120 0.298

UTB -0.147 1.00 -0.002

Tax Risk 0.135 -0.090 1.00

Panel B: Cash ETR and Tax Risk ETR Quintiles

Number of observations in each quintile (~667 in each cell if evenly distributed)

Tax Risk

Quintile 1

Tax Risk

Quintile 2

Tax Risk

Quintile 3

Tax Risk

Quintile 4

Tax Risk

Quintile 5 Total

Cash ETR Quintile 1 871 605 641 690 531 3,338




Cash ETR Quintile 5 495 572 540 547 1,183 3,337

Total 3,338 3,337 3,337 3,337 3,337 16,686

Panel C: UTB and Tax Risk Quintiles


Tax Risk

Quintile 1

Tax Risk

Quintile 2

Tax Risk

Quintile 3

Tax Risk

Quintile 4

Tax Risk

Quintile 5 Total

UTB Quintile 1 64 49 78 94 107 392

UTB Quintile 2 79 77 76 80 80 392

UTB Quintile 3 83 88 81 85 55 392

UTB Quintile 4 86 83 82 73 68 392

UTB Quintile 5 80 95 75 60 82 392

Total 392 392 392 392 392 1,960

Panel D: Persistence of High and Low Tax Avoidance

(z-statistic)

VARIABLES

Lowest Cash ETR

Quintile

(1)

Highest Cash ETR

Quintile

(2)

Lagged Lowest ETR Quintile 2.346***

(28.13)

Lagged Highest ETR Quintile

1.211***

(16.11)

Number of Observations 6,360 6,360

Pseudo R^2 0.170 0.086

Year Fixed Effects? Yes Yes

35

Table 3: (Continued)

Panel E: Pairwise Correlations of Variables

Variablesa

I II III IV V VI VII VIII IX X XI XII

I Volatility of

Stock Returns 1.000 0.005 0.099 0.130 0.300 0.066 -0.067 -0.258 0.025 0.056 0.031 -0.149

II Cash ETR 0.024 1.000 0.298 0.013 -0.004 0.117 -0.126 -0.157 -0.043 0.002 0.207 -0.178

III Tax Risk 0.118 0.135 1.000 -0.199 0.098 0.221 0.026 -0.131 0.007 0.057 0.135 -0.169

IV PTBI 0.126 0.073 -0.309 1.000 0.395 -0.498 -0.301 -0.191 0.035 -0.103 -0.077 0.040

V Volatility of

PTBI 0.376 0.037 0.113 0.343 1.000 -0.134 -0.178 -0.255 0.050 0.019 -0.009 -0.084

VI Book to

Market -0.008 0.118 0.263 -0.590 -0.186 1.000 0.032 -0.217 -0.039 0.230 0.257 -0.393

VII Leverage -0.129 -0.141 0.053 -0.403 -0.293 0.118 1.000 0.281 -0.042 -0.020 -0.039 0.113

VIII Size -0.265 -0.211 -0.131 -0.172 -0.305 -0.197 0.359 1.000 0.006 -0.065 -0.480 0.894

IX Abnormal

Accruals 0.138 -0.060 0.045 0.130 0.197 -0.109 -0.149 -0.110 1.000 0.029 -0.066 0.034

X Return -0.059 0.005 0.040 -0.115 -0.007 0.199 -0.010 -0.019 0.009 1.000 0.043 -0.049

XI Institutional

Ownership -0.012 0.229 0.124 -0.093 -0.042 0.256 -0.031 -0.477 -0.061 0.016 1.000 -0.463

XII Shares

Outstanding -0.152 -0.216 -0.197 0.051 -0.124 -0.401 0.168 0.896 -0.043 -0.018 -0.488 1.000

This table provides data on the pairwise correlations between the tax policy measures. In Panels A and E, Pearson

correlation coefficients are above the diagonal and Spearman Rank correlations are below the diagonal. Panels B

and C demonstrate the relations between tax risk and levels of tax avoidance (Panel B) and tax aggressiveness

(Panel C). Data in Panels A and C are limited to observations for which UTB data are available. Panel D presents

the results from a logit regression with the dependent variable equal to one if the firm is in the lowest (highest)

quintile of the Cash ETR. The independent variables are indicator variables equal to one if the firm is in the lowest

(highest) quintile of the Cash ETR distribution in the prior (non-overlapping) five-year period. Tax risk is the

standard deviation of the annual Cash ETR over a five year period. Detailed definitions for the variables are reported

in Appendix B.

36

Table 4:

Determinants of High Tax Avoidance, High Tax Aggressiveness and High Tax Risk

VARIABLES

High Tax

Avoidance

(1)

High Tax

Aggressiveness

(2)

High Tax

Risk

(3)

Size 0.108* 0.208*** -0.231***

(1.56) (3.41) (-4.54)

PPE 1.182** -1.329** 0.241

(2.47) (-2.46) (0.58)

Foreign_Sales 0.720 1.747*** -0.084

(1.19) (3.00) (-0.16)

R&D 12.704*** 10.343*** 0.431

(5.80) (4.75) (0.19)

Intang_Assets 0.428 -0.833 -1.158**

(0.90) (-1.58) (-2.72)

ESO_Benefit 55.879*** 16.492 -87.879***

(3.17) (0.89) (-3.93)

Leverage 1.011* 0.570 1.043**

(1.93) (0.89) (2.06)

Year Fixed Effects? Yes Yes Yes

R^2 0.077 0.098 0.051

Observations 1,960 1,960 1,960

*,**

, and ***

indicate statistical significance at the 0.10, 0.05 and 0.01 levels, respectively.

The dependent variable is either set equal to one if the observation is in the lowest quintile of Cash ETR and zero

otherwise (Column 1 High Tax Avoidance), equal to one if the observation is in the highest quintile of unrecognized

tax benefits and zero otherwise (Column 2 High Tax Aggressiveness), or equal to one if the observation is in the

highest quintile of the standard deviation of Cash ETR and zero otherwise (Column 3 High Tax Risk),. T-statistics

are in parenthesis and reflect standard errors clustered by firm. Intercepts and Year Effects are included in the

analysis but are not tabulated. All variables are defined in Appendix B.

37

Table 5:

The Relation between Tax Policies and Firm Risk

Panel A: Full Sample

VARIABLES

Predicted

Sign 1 2 3 4

Cash ETR (-) 0.472

0.374

(0.84)

(0.69)

Tax Risk (+)

1.916***

1.555***

(4.61)

(3.72)

PTBI (-)

1.823*** 2.130***

(2.75) (3.21)

Vol_of_PTBI (+)

11.53*** 10.76***

(6.93) (6.40)

BTM (-)

0.267 0.224

(1.04) (0.88)

Leverage (+)

2.344*** 2.302***

(6.94) (6.86)

Size (-)

-0.725*** -0.675***

(-4.26) (-3.99)

Abn_Accruals (+)

0.0381 0.0386

(0.66) (0.67)

Return (-)

0.368*** 0.368***

(3.12) (3.12)

Inst_Own (+)

0.546 0.542

(1.54) (1.54)

Shares_Out (+) 0.319** 0.325**

(2.18) (2.23)

Constant (?) 9.326*** 9.237*** 10.82*** 10.48***

(21.23) (23.23) (12.07) (11.89)

Firm Fixed Effects? Yes Yes Yes Yes

Year Fixed Effects? Yes Yes Yes Yes

N 16,686 16,686 16,686 16,686

R-Squared 0.220 0.221 0.233 0.234

38

Table 5:

The Relation between Tax Policies and Firm Risk

Panel B: UTB Sample

VARIABLES

Predicted

Sign 1 2 3 4 5 6

Cash ETR (-) 1.970 -0.407

(1.25) (-0.33)

UTB (+) -11.55 9.209

(-1.44) (1.23)

Tax Risk (+) 5.785*** 2.659***

(4.56) (2.59)

PTBI (-) -2.254 -2.407* -1.392

(-1.60) (-1.69) (-0.92)

Vol_of_PTBI (+) 22.98*** 22.66*** 20.76***

(6.44) (6.21) (5.95)

BTM (-) 2.564*** 2.608*** 2.580***

(5.49) (5.58) (5.63)

Leverage (+) 3.810*** 3.766*** 3.759***

(5.48) (5.42) (5.45)

Size (-) -0.787*** -0.774*** -0.769***

(-4.75) (-4.67) (-4.69)

Abn_Accruals (+) 0.171** 0.172** 0.167**

(2.19) (2.21) (2.16)

Return (-) 0.0529 0.0419 0.00766

(0.19) (0.15) (0.03)

Inst_Own (+) -2.536*** -2.557*** -2.624***

(-4.40) (-4.43) (-4.66)

Shares_Out (+) 0.0724 0.0331 0.0866

(0.37) (0.17) (0.45)

Constant (?) 13.17*** 13.84*** 13.28*** 19.33*** 19.20*** 18.89***

(33.23) (45.76) (52.46) (20.94) (22.03) (21.05)

Industry Fixed Effects? Yes Yes Yes Yes Yes Yes

Year Fixed Effects? Yes Yes Yes Yes Yes Yes

N 1,960 1,960 1,960 1,960 1,960 1,960

R-Squared 0.279 0.279 0.300 0.412 0.413 0.416

*,**

, and ***

indicate statistical significance at the 0.10, 0.05 and 0.01 levels, respectively. The dependent variable in

the analysis is the volatility of stock returns at year t+1. T-Statistics are in parenthesis and reflect standard errors that

are clustered by firm. All variables are as defined in Appendix B. For expositional convenience we multiply all

coefficients by 100.

39

Table 6:

The Relation between Extreme Tax Policies and Firm Risk

Panel A: Full Sample

VARIABLES

Predicted

Sign 1 2 3 4

Low Cash ETR (+) -0.0777

-0.0632

(-0.59)

(-0.50)

High Tax Risk (+)

0.422***

0.308***

(3.56)

(2.69)

PTBI (-)

1.814*** 1.949***

(2.73) (2.93)

Vol_of_PTBI (+)

11.57*** 11.22***

(6.95) (6.74)

BTM (-)

0.271 0.237

(1.06) (0.93)

Leverage (+)

2.337*** 2.316***

(6.93) (6.91)

Size (-)

-0.723*** -0.698***

(-4.25) (-4.12)

Abn_Accruals (+)

0.0385 0.0377

(0.67) (0.65)

Return (-)

0.368*** 0.370***

(3.12) (3.14)

Inst_Own (+)

0.549 0.535

(1.55) (1.51)

Shares_Out (+) 0.314** 0.319**

(2.15) (2.18)

Constant (?) 9.491*** 9.386*** 10.95*** 10.75***

(24.24) (23.88) (12.45) (12.17)



N 16,686 16,686 16,686 16,686

R-Squared 0.218 0.220 0.233 0.233

40

Table 6:

The Relation between Extreme Tax Policies and Firm Risk

Panel B: UTB Sample

Predicted

VARIABLES Sign 1 2 3 4 5 6

Low Cash ETR (-) -0.0672

0.118

(-0.23)

(0.48)

High Tax Risk (+)

1.501***

0.543**

(5.19)

(1.98)

High UTB (+)

-0.385

0.195

(-1.20)

(0.70)

PTBI (-)

-2.229 -1.820 -2.335

(-1.56) (-1.25) (-1.65)

Vol_of_PTBI (+)

22.83*** 21.56*** 22.65***

(6.21) (5.93) (6.20)

BTM (-)

2.556*** 2.515*** 2.584***

(5.52) (5.45) (5.56)

Leverage (+)

3.809*** 3.806*** 3.815***

(5.49) (5.53) (5.50)

Size (-)

-0.785*** -0.778*** -0.786***

(-4.74) (-4.75) (-4.75)

Abn_Accruals (+)

0.171** 0.168** 0.171**

(2.18) (2.16) (2.19)

Return (-)

0.0560 0.0595 0.0409

(0.20) (0.22) (0.15)

Inst_Own (+)

-2.543*** -2.569*** -2.561***

(-4.41) (-4.48) (-4.44)

Shares_Out (+)

0.0695 0.0817 0.0626

(0.35) (0.42) (0.32)

Constant (?) 13.60*** 13.58*** 13.61*** 19.25*** 19.15*** 19.32***

(54.80) (54.71) (54.95) (21.92) (21.62) (21.67)

Industry Fixed Effects?

Yes Yes Yes Yes Yes Yes

Year Fixed Effects?

Yes Yes Yes Yes Yes Yes

N

1,960 1,960 1,960 1,960 1,960 1,960

R-Squared 0.277 0.294 0.278 0.412 0.414 0.412

*,**

, and ***





41

Table 7

Coefficient of Variation of Cash ETR

Panel A: Pairwise Correlations

Cash ETR UTB

Coefficient

of Variation

Cash ETR 1.00 -0.129 -0.281

UTB -0.159 1.00 0.058

Coefficient of Variation -0.361 0.001 1.00

Panel B: Cash ETR and Coefficient of Variation of ETR Quintiles


Coefficient

of Variation

Quintile 1

Coefficient

of Variation

Quintile 2

Coefficient

of Variation

Quintile 3

Coefficient

of Variation

Quintile 4

Coefficient

of Variation

Quintile 5

Total

Cash ETR Quintile 1 94 238 441 899 1,638 3,310



Cash ETR Quintile 4 1,139 845 639 422 264 3,309


Total 3,310 3,309 3,310 3,309 3,309 16,547

Panel C: UTB and Tax Risk Quintiles


Coefficient

of Variation

Quintile 1

Coefficient

of Variation

Quintile 2

Coefficient

of Variation

Quintile 3

Coefficient

of Variation

Quintile 4

Coefficient

of Variation

Quintile 5

Total

UTB Quintile 1 68 66 75 80 103 392

UTB Quintile 2 92 79 80 67 73 391

UTB Quintile 3 91 80 89 76 55 391

UTB Quintile 4 84 90 66 84 67 391

UTB Quintile 5 57 76 81 84 93 391

Total 392 391 391 391 391 1,956

Panels A, B, and C in this table provides data on the relation between the coefficient of variation of Cash ETR and

other tax policy measures. In Panel A, Pearson correlation coefficients are above the diagonal and Spearman Rank

correlations are below the diagonal. Panels B and C demonstrate the relations between the coefficient of variation

and levels of tax avoidance (Panel B) and tax aggressiveness (Panel C). Detailed definitions for the variables are

reported in Appendix B.

42

Table 7: (Continued)

Panel D: The Coefficient of the Cash ETR and Firm Risk

VARIABLES

Full

Sample

Full

Sample

UTB

Sample

UTB

Sample

Coefficient of variation 0.534*** 0.370*** 1.754*** 0.818***

(3.79) (2.67) (5.38) (2.87)

PTBI

2.101*** -1.483

(3.13) (-1.01)

Vol_of_PTBI

11.39*** 22.27***

(6.70) (6.00)

BTM

0.267 2.543***

(1.04) (5.49)

Leverage

2.300*** 3.745***

(6.74) (5.42)

Size

-0.676*** -0.758***

(-3.95) (-4.61)

Abn_Accruals

0.0225 0.174**

(0.38) (2.19)

Return

0.353*** 0.0541

(3.00) (0.20)

Inst_Own

0.519 -2.498***

(1.45) (-4.34)

Shares_Out 0.294** 0.0717

(2.00) (0.37)

Constant 9.302*** 10.59*** 13.12*** 18.72***

(22.64) (11.80) (49.41) (20.81)



N 16,547 16,547 1,956 1,956

R-Squared 0.222 0.235 0.293 0.414

*,**

, and ***





Documents

Tax Avoidance, Tax Aggressiveness, Tax Risk and Firm Risk David