There is a lot of interest among investors, regulators and researchers in understanding the extent to which companies take intentional steps to avoid paying taxes. A new study highlights the fact that many companies unintentionally avoid paying taxes and outlines why this is important for observers to keep in mind.
Sometimes companies do intentionally engage in legal business practices designed specifically to reduce their tax burden. However, there are also cases of incidental tax avoidance, which can refer to two things. First, it could be a circumstance that a company has little control over – such as taking financial losses in recent years – that reduces a company’s tax burden. Second, it can refer to actions that a company takes for operational purposes – such as repairing a damaged facility – that also reduce the company’s tax burden.
“For example, for many years Tesla took losses – it was not profitable,” says Christina Lewellen, co-author of a paper on the work and an associate professor of accounting in North Carolina State University’s Poole College of Management. “As a result, their tax burden was essentially zero. While the company took heat from critics who alleged the company engaged in intentional tax avoidance, an in-depth examination of their operations provides no such clarity. It’s entirely possible that the low tax burden was incidental.”
Understanding the role that incidental tax avoidance plays can be important for a number of reasons. For example, investors could be wary of companies engaging in risky tax planning strategies. It’s important for those investors to be aware that the tax avoidance estimates based on tax numbers in financial reports may be unintentional, rather than the result of careful planning.
“Similarly, if policymakers are considering legislation or regulations aimed at getting companies to pay their fair share of taxes, they need to be aware that there are instances where a company’s low tax burden stems from incidental circumstances, or clear tax preferences that the lawmakers put in place, rather than making use of tax loopholes,” Lewellen says.
“Also, many business researchers study the economic consequences of intentional actions companies take to reduce tax payments. That makes it critical for researchers to account for the possibility that tax avoidance was not intentional when drawing conclusions from their work.”
The biggest challenge for anyone trying to determine whether tax avoidance estimated from a company’s financial statements was intentional or incidental is the fact that it is effectively impossible for outside observers to make such a determination – they don’t have access to internal company information that could help make such a determination possible.
“Our work here advances the discussion by presenting a complex conceptual and mathematical definition of incidental tax avoidance,” Lewellen says. “This does not allow us to identify intentional tax avoidance based on a company’s public-facing financial statements. But it does give us a framework that can help identify at least some of the ways in which tax avoidance can be incidental rather than intentional.
“In essence, it’s a critical thinking guide that has outside observers look at the ways in which incidental factors may have played a role, rather than assuming that all tax avoidance is the result of administrative maneuvering.”
The researchers found that utilizing their framework offered new insights when applied to previous research on tax avoidance.
“For example, previous published work had found that companies with more aggressive tax avoidance paid higher interest rates for loans,” Lewellen says. “Applying our framework to the data used in that study, we looked for incidental tax reduction factors that might have contributed to higher interest rates, such as whether a company had been unprofitable in the past. We found that past losses that incidentally reduced current taxes were responsible for the higher interest rates, rather than aggressive tax planning as concluded by the study’s authors.
“That offers a different perspective on the correlation between high tax avoidance and high interest rates than if one were to assume that the tax avoidance was intentional, which is relevant for both researchers and policymakers.”
The paper, “Endogeneity and the Economic Consequences of Tax Avoidance,” is published open access in the journal Contemporary Accounting Research. The paper was co-authored by Scott Dyreng of Duke University, Robert Hills of Penn State University, and Bradley Lindsey of Utah State University.
