Are Low Taxes a Sign of Risky Business Management?

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Terry Sheridan
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Corporate tax avoidance isn’t always driven by risk-taking managers but rather by astute managerial and legal guidance, according to a provocative new study published by the American Accounting Association.

“The current statutory rate may not be to companies’ liking, but we don’t find that it’s driving managers into risky behavior,” University of Oregon accounting professor David Guenther, who co-authored the study, said in a prepared statement. “Our findings suggest a firm’s low taxes to be more reflective of skilled management than risky management.”

Guenther’s colleagues on the study, Is Tax Avoidance Related to Firm Risk? included accounting professor Steven Matsunaga of the University of Oregon and assistant business professor Brian Williams of Indiana University. The study was published in the January/February issue of the The Accounting Review.

The professors acknowledge that some corporate tax avoiders will face consequences. But, overall, their findings fly in the face of research indicating that “major segments of the business and financial community, including banks, audit firms, labor unions, and professional investment advisors, commonly harbor suspicions about firms that manage low rates,” the study states. “Low taxes, the thinking goes, are a warning light for excessive risk-taking that could lead to future company troubles – such as from challenges by the IRS to aggressive tax positions or from dubious investments in low-taxing but unstable corners of the world or from tax-related managerial misfeasance.”

The study describes various scenarios and explanations for the findings, including how likely enforcement is. For example, if a company uses “benign tax-favored investments” that the IRS likely won’t question or courts rule against – such as municipal bond investments – then the company’s tax avoidance and lower tax payments generally won’t be followed by future high payments, the study states.

Further, avoidance tactics will only bring future high payments if the IRS steps in and successfully challenges them, the professors write – and that’s unlikely.

“Even if the measures reflect management’s tendency to take positions to reduce their tax payments that are likely to be rejected based on their merits, in actual practice, the positions are not reversed in the future, either because they are not identified and challenged, or because the firm’s legal representation is able to reach a favorable outcome,” they state.

The professors conducted three risk tests:

  • If a company’s low effective tax rates are temporary and “less persistent” than higher rates.
  • If the low tax rates are better indicators than higher rates of future tax volatility.
  • If lower rates are linked to more uncertainty about the company’s future cash flow as reflected in increased future stock price volatility.

In all three tests, low taxes were not associated with corporate risk, the study states. However, there is one indicator of future financial trouble. The professors believe that tax rate volatility points to future stock price volatility. Why?

“Past volatility leads to greater uncertainty regarding the firm’s future tax rate and overall uncertainty regarding the firm’s future cash flows,” the study states.

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