How Quickly Do Firms Adjust to Optimal Levels of Tax Avoidance?

Abstract

The trade‐off literature asserts that managers weigh the direct benefits of tax avoidance against the associated nontax costs. This literature implies each firm has a unique optimal level of tax avoidance that balances these costs and benefits. Our study is the first to document how quickly the average firm moves toward its optimal level of tax avoidance. We find that the typical firm converges toward its optimum at a rate that ranges from approximately 69 to 84 percent over a three‐year period, depending upon model specifications. Consistent with asymmetric levels of frictions across the tax avoidance distribution, we find the speed of adjustment is greater for firms below their optimal level of tax avoidance than for firms above. We perform additional cross‐sectional analyses to provide insight into some of the frictions that prevent firms from adjusting completely to their optimal level of tax avoidance. We generally find growth firms exhibit slower adjustment speeds and provide limited evidence that both multinational firms and income‐mobile firms exhibit faster adjustment speeds.

Tax avoidance and ex ante cost of capital

“…Results from this estimation provide evidence on whether firms have expected levels of tax avoidance and, consistent with Kim et al. (), move toward those expected levels in the subsequent year.…”

“…Second, we provide additional evidence supporting Kim et al. () that firm‐specific, expected levels of tax avoidance exist and that firms attempt to align their reported levels of tax avoidance with these expected levels. We find that the ex ante cost of equity capital increases with the deviation from investors’ expectations of tax avoidance, and this result occurs for firms with reported levels of tax avoidance both above (too much avoidance) and below (not enough avoidance) expected levels.…”

“…However, while Kim et al. () provide evidence of target tax‐avoidance levels, their study provides little evidence on the factors that underlie these targeted tax‐avoidance levels or the reasons that firms return to those target levels when deviations occur. We suggest that one large non‐tax cost is firms’ ex ante cost of equity capital and that deviations from investor expectations of tax avoidance have a substantial effect on firms’ ex ante cost of capital.…”

“…Supporting this balancing of tax benefits and non‐tax costs, Kim et al. () provide initial evidence suggesting firms have unique, target levels of tax avoidance that maximize firm value and attempt to return to these target levels of tax avoidance when deviations occur. However, while Kim et al.…”

“…However, Kim, et al. () note that, in a dynamic world, firms may establish a new firm‐value‐maximizing target level of tax avoidance and modify their tax‐avoidance activities accordingly. Thus, consistent with the Scholes et al.…”