How Reliably Do Empirical Tests Identify Tax Avoidance?

Abstract

Research on the determinants of tax avoidance have relied on tests using GAAP and cash effective tax rates (ETRs) and total and permanent book‐tax differences. Two new proxies have emerged that overcome documented limitations of these proxies: one, developed by Henry and Sansing (2018), allows for more meaningful interpretation of results estimated in samples that include loss observations. The other, reserves for unrecognized tax benefits (UTB), provides new data on tax uncertainty. We offer empirical evidence on how well tests using these new proxies perform relative to those extensively used in prior research. The paper finds that tests using the proxy developed by Henry and Sansing (2018) have lower power relative to those using other proxies across all samples, including a sample that includes loss observations. In contrast, when firms accrue reserves for uncertain tax avoidance, tests using the current‐year addition to the UTB have the highest power across all proxies, samples, and levels of reserves. In the absence of reserves, tests using the GAAP ETR best detect uncertain tax avoidance, on average. This study contributes to the literature by using a controlled environment to provide the first large‐scale empirical evidence on how the power of tests varies with the use of relatively new proxies, the inclusion of loss observations, and the advent of FIN 48.

Corporate tax risk: a literature review and future research directions

“…Volatility is measured as the standard deviation value of tax avoidance proxies (such as effective tax rates (ETR), cash ETR (CETR), and GAAP ETR Furthermore, the tax risk can also be measured as the probability that the firm is engaged in tax sheltering (Rego and Wilson, 2012), along with unrecognized tax benefits (see, e.g., Rego and Wilson 2012;Powers et al 2016;Hanlon et al 2017;Alsadoun et al 2018;Dyreng et al 2019;Guenther et al 2019;Saavedra 2019). De Simone et al (2020) reveal that the reserves for unrecognized tax benefits (UTB) can be considered as a proxy for tax uncertainty. Specifically, tests employing UTB (current-year additions to the UTB) have the biggest power when corporates reserve for tax risk (tax uncertainty) (De Simone et al 2020).…”

“…De Simone et al (2020) reveal that the reserves for unrecognized tax benefits (UTB) can be considered as a proxy for tax uncertainty. Specifically, tests employing UTB (current-year additions to the UTB) have the biggest power when corporates reserve for tax risk (tax uncertainty) (De Simone et al 2020). Meanwhile, tests utilizing GAAP ETR possess the largest power when corporates do not accrue for uncertain tax avoidance (De Simone et al 2020).…”

“…Specifically, tests employing UTB (current-year additions to the UTB) have the biggest power when corporates reserve for tax risk (tax uncertainty) (De Simone et al 2020). Meanwhile, tests utilizing GAAP ETR possess the largest power when corporates do not accrue for uncertain tax avoidance (De Simone et al 2020). Moreover, by using disclosure data, the tax risk can be estimated as the natural log of keywords related to the tax risks in a firm's tax risk factor disclosure (Campbell et al2019).…”

Determinants and consequences of auditor‐provided tax services: A systematic review of the international literature

“…Other tax-related consequences Tax avoidance. Tax avoidance is used to describe activities or strategies that would reduce firms' explicit tax liability (Brühne & Jacob, 2021;De Simone et al, 2020;Dyreng et al, 2008;Hanlon & Heitzman, 2010). Auditors are proscribed from providing tax services for achieving aggressive tax positions to avoid taxes (e.g., PCAOB Rule 3522 in the United States).…”

The Geography of Corporate Tax Avoidance.

“…It is important to note that neither of these measures is able to capture tax avoidance perfectly. ETR captures only permanent tax strategies and is affected by managerial decisions related to financial reporting for income taxes (De Simone, Nickerson, Seidman and Stomberg, 2016). In contrast, CETR captures both permanent and temporary tax strategies, but is more volatile as it can be affected by any action that reduces a firm's explicit tax liability (Dyreng et al, 2010).…”