I will test the hypothesis in this study based on the results of the t-test on the digit with an unusually high frequency in the financial statements of avoiders. As mentioned above, the test sample will be used in a regression model to see if the finding of the first test is correct and persists when controls are included for firm characteristics which are associated with cash effective tax rates. More specifically, firm characteristics which have been proven to be a determinant of corporate tax avoidance in prior research.
The following regression model is estimated to test the hypothesis stated in this study:
CASH ETRi,t = β0 + β1HIGH FREQi,t + β2ROAi,t + β3LEVi,t + β4NOLi,t + β5∆NOLi,t ...view middle of the document...
One limitation of the annual CASH ETR is that the numerator and denominator could be misaligned. This is the case when the numerator, thus cash taxes paid contains taxes paid on earnings in a different period, for example, earnings from an IRS audit which was completed in the current year, while the denominator “pre-tax income” contains earnings solely from the current year (Hanlon and Heitzman 2010). A second limitation is that the CASH ETR does not capture the changes in tax accounting accruals. The CASH ETR for firm i for the year t is measured as follows:
Cash taxes paidi,t / Pre-tax incomei,t.
The variable of interest in this study is HIGH FREQ, which is dummy variable that is equal to one if a firm has an unusually high frequency of a certain digit, and zero otherwise. Firms that are tax avoiders usually have a low cash effective rate. Therefore, I expect a negative coefficient on the HIGH FREQ variable implying that the firms with an unusually high frequency of a certain digit have a negative influence on the CASH ETR. There are different controls for firm characteristics that have been reported to be associated with tax avoidance measures. I use the same control variables for firm characteristics as Chen et al. (2010).
Return on asset (ROA) is calculated as the pre-tax income deducted by extraordinary items divided by lagged assets. Return on assets generally measures the profitability and operations of a firm. Effective tax rates are an outcome of the proportion of tax incentives to financial accounting income. In this case, tax incentives, such as depreciation, are items that create differences between financial accounting income and taxable income. To the extent that tax inducements are not consistently associated with financial accounting income, effective tax rates can be altered because of changes in financial accounting income. Thus, ROA captures changes in the operating results of a firm (Richardson and Lanis 2007). In contrast, Manzon and Plesko (2001) state that firms which are more profitable are able to use tax deductions and tax credits and benefit from tax exemptions. Therefore, they have more resources to engage in tax avoidance activities. Profitable firms have an advantage compared to firms that are not profitable in that they can use for example, tax exemptions and tax deductions to minimize taxable income which in turn will increase book-tax differences. Their results are consistent with this notion. In contrast, studies by Gupta and Newberry (1997), Richardson and Lanis (2007), Chen et al. (2010) find that firms that are more profitable usually have higher effective tax rates. Therefore I do not have a certain prediction on the association between the ROA and the CASH ETR variables.
Leverage (LEV) is computed as long-term debt divided by lagged assets. Financing decisions of a firm may have an effect on effective tax rates. This is because tax laws usually allow differential tax treatment to the capital...