While the high US corporate tax rate is typically what grabs attention, a new study published by the American Accounting Association makes the argument that the growth of passive institutional investor-owners in corporations promotes tax avoidance.
The study, Institutional Ownership and Corporate Tax Avoidance: New Evidence, featured in the March/April issue of The Accounting Review, focuses on “quasi-indexers” – passive investors with diversified holdings. But these investors aren’t actively promoting tax avoidance, say study authors Mozaffar Khan, accounting professor at the University of Minnesota; Suraj Srinivasan, professor of business administration at Harvard University; and Liang Tan, assistant professor of accountancy at George Washington University.
That’s for two reasons.
First, passive investors are interested in increasing shareholders’ after-tax income, so “any combination of feasible cost-reduction strategies chosen by managers will do,” the study states. Further, managers are incentivized to improve after-tax performance to justify their pay to new investors – and the newbies will be more attuned to the pay-performance ratio.
“In this scenario, taxes are just another line-item expense and institutional owners do not have to explicitly dictate which line item – taxes, research and development, advertising, payroll, or other expenses – managers should manage better,” the study states.
Second, many quasi-indexers manage pension and other funds. Engaging in overt tax avoidance would draw the attention of media, regulatory, and consumer interest groups toward the firms and their large investors in what the study terms “tax shaming.”
“Of course, these same fund managers would likely enjoy private benefits (e.g., compensation and job prospects) from tax avoidance that results in improved firm and fund performance,” the study states. “This implies that institutional investors are unlikely to explicitly promote tax avoidance, relying instead on the latent demand implicit in their demand for better firm financial performance or on private communication to that effect.”
Thus, manipulating taxes is an alluring avenue for managers to take. That’s especially true when considering the complexities of the tax code.
The professors found that firms at the top of the Russell 2000, with their high index weight, had 20 percent more institutional ownership than those at the bottom of the Russell 1000 Index. Whether measured by taxes acknowledged on financial statements or taxes actually paid, higher institutional ownership was found to foster tax avoidance, which was achieved to a significant extent through the use of tax shelters.
In addition, tax avoidance, by increasing after-tax income, provided a means of meeting or beating analysts’ earnings forecasts and increasing the ratio of net income to sales – two achievements closely tracked by equity investors.
The professors say they view the “positive relation between ownership concentration and tax avoidance as quite robust.”
In the meantime, smaller companies are at a disadvantage because they lack the ability to take advantage of the tax code’s complexity, the study finds.
“One can’t help being struck by the malleability of corporate taxation that emerges when company managers confront increased institutional ownership,” Khan said in a prepared statement. “Evidently out of eagerness to impress their new owners, managers are able to substantially reduce taxes owed and taxes paid within the next year or 18 months.”
Khan hopes that the study’s findings will lead to a simpler tax code “and level the playing field, so that companies that lack the means of bigger firms to exploit the current system do not have to carry the corporate tax burden to the extent they do today.”