Tax avoidance

If corporate tax reform is high on the national economic agenda, the time is none too soon, a new study suggests.

While criticism of the current tax law most commonly targets its high statutory rate, the new research underscores another important issue: the significant disadvantage the IRS code imposes on smaller companies that lack the means to exploit its sheer complexity.

The study, published in the March issue of The Accounting Review, published by the American Accounting Association, raises this concern with its focus on passive institutional investing. This form of ownership has quadrupled over the past two decades, greatly increasing the overall volume of institutional investing.

And increased institutional ownership of a company’s stock has a “significantly positive relationship” with the company’s use of tax avoidance strategies, the study found.

Why does this occur? According to the study’s authors, management of companies with new institutional owners may have heightened incentive to show better after-tax performance in order to justify their compensation. And tax manipulation, the study suggests, presents an inviting way for managers to do so, given the byzantine complexities of the tax code.

Tax shelters “occupy the more complex segment of the spectrum of tax avoidance,” the authors wrote.

“One can’t help being struck by the malleability of corporate taxation that emerges when company managers confront increased institutional ownership,” says Mozaffar Khan of the University of Minnesota, a co-author of the study along with Suraj Srinivasan of Harvard Business School and Liang Tan of George Washington University.

“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 adds. “Hopefully, our findings will spur efforts to simplify the 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.”

The findings reinforce those of a paper published in the previous (January-February) edition of The Accounting Review. The paper, by Andrew Bird and Stephen Karolyi of Carnegie Mellon University, found that a 10% increase in institutional ownership “precedes declines in effective tax rates on the order of two percentage points.”

In addition, Bird and Karolyi reported that a one-percentage-point increase in institutional ownership is associated with a 1.3% increase in the likelihood of having a subsidiary in at least one tax-haven country, a 2.2% increase in the number of subsidiaries in tax havens in total, and a 0.6% increase in the number of distinct tax-haven countries in which a firm is active.

Considering the results of the studies, shouldn’t the problematic effects on taxation engendered by institutional ownership lead institutions to discourage this avoidance?

No, the professors say. “Given the fiduciary duty of fund managers to their constituencies and the many issues involved in company governance besides taxation, one needs to be careful about prescribing management strategies,” says Khan.

“Rather than scolding companies and institutional investors,” he adds, “the priority should be to simplify corporate taxation so that the opportunities for avoidance we documented are no longer a temptation for big firms and a bane for smaller ones.”

The study, entitled “Institutional Ownership and Corporate Tax Avoidance: New Evidence,” is in the March/April issue of The Accounting Review.

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