A common refrain among many major segments of the business and financial community—including banks, audit firms, labor unions, and professional investment advisers—is that low tax payments are a warning light for excessive risk-taking.
That risk-taking could lead to future company troubles, such as challenges by the IRS or lack of security due to dubious investments in low-taxing but unstable corners of the world. But do the numbers bear this speculation out?
In “Is Tax Avoidance Related to Firm Risk?" Scharpf Professor of Accounting David Guenther, Johnson Memorial Professor of Accounting Steven Matsunaga, and Brian M. Williams, PhD '15, now of Indiana University, find that in most cases, the assumption that low taxes equal risky tax choices isn't consistent with the evidence.
“The current statutory rate (35 percent) may not be to companies" liking, but we don't find that it's driving managers into risky behavior," Guenther said. “Our findings suggest a firm's low taxes to be more reflective of skilled management than risky management."
What does appear to be a harbinger of future risk is not a low tax rate but tax-rate volatility—which the researchers found to be predictive of future stock-price volatility. A potential explanation for this is that “past volatility leads to greater uncertainty regarding the firm's future tax rate and overall uncertainty regarding the firm's future cash flows," the authors write.
The study's findings are based on analyses of the finances and taxes of a large sample of firms over a 25-year period. Effective tax rates were calculated both for taxes that firms acknowledged on financial statements and tax payments actually made over three-year and five-year periods.
Guenther explained how the paper was one of his favorite research projects in a profile written when he received the Lundquist College's 2017 Stewart Professorship.
Given the researchers" findings, what then accounts for the common assumption in business and finance that low tax payments are a warning of excessive risk-taking? One possible explanation, the authors contend, is the absence of enforcement.
They write, “aggressive tax positions will only result in high future payments if the IRS identifies the issue, chooses to challenge the position, and is successful in their challenge."
In the end, the professors lean toward a less negative interpretation.
They write that the findings are most consistent with the idea that low effective tax rates reflect the extent to which a firm's operations allow it to take advantage of benign—but more favorable—transactions, not to differences in managers" willingness to reduce the firm's tax payments through risky tax positions.