Tax Aggressiveness and Corporate Transparency

Abstract

We investigate whether aggressive tax planning firms have a less transparent information environment. Although tax planning provides expected tax savings, it can simultaneously increase the financial complexity of the organization. And to the extent that this greater financial complexity cannot be adequately clarified through communications with outside parties, such as investors and analysts, transparency problems can arise. Our investigation of the association between tax aggressiveness and information asymmetry, analysts' forecast errors, and earnings quality suggests that aggressive tax planning is associated with lower corporate transparency. We also find evidence that managers at tax-aggressive firms attempt to mitigate these transparency problems by increasing various tax-related disclosures. Overall, our results suggest that firms face a trade-off between tax benefits and financial transparency when choosing the aggressiveness of their tax planning. JEL Classifications: G30; H26; M41.

Does Tax Planning Affect Analysts' Forecast Accuracy?

“…These results suggest analysts may not fully understand the implications of tax planning for earnings. Our results are robust to alternative model specifications, in addition to controlling for proxies of tax reporting complexity and ex post tax avoidance (e.g., Donelson et al 2016;Bratten et al 2017;Balakrishnan et al 2019). We conduct several tests to corroborate the results and rule out alternative explanations.…”

“…Moreover, the effect of these choices will differ from the effect that would have occurred if the transaction had been completed absent tax considerations. Thus, tax planning often generates additional complexity (Mills et al 1998;Balakrishnan et al 2019), which could make it more difficult to predict earnings.…”

“…Tax planning can require the legal separation of business activities to exploit tax treaties, engage in multi-state tax planning, move income and expenses via transfer pricing, deduct losses, and so on. (Balakrishnan et al 2019). For example, Google uses tax treaties to avoid paying withholding taxes on its European earnings by passing its revenue through subsidiaries located in three different countries (Drucker 2010 Based on data in Audit Analytics, we find that 75 percent of firm-year observations hire their auditor for tax services.…”

“…Our study provides evidence supporting the assumption of Allen et al (2016) that tax planning impedes analysts' understanding of firms. In that regard, our study relates to the work of Bratten et al (2017), Donelson et al (2016), and Balakrishnan et al (2019), who find that measures of tax reporting complexity, disclosures of nonrecurring income taxes, and ex post industryadjusted tax avoidance are associated with the accuracy of analysts' forecasts. We build on this work by demonstrating the broad effect of tax planning on analysts' tax expense estimation and EPS forecasts.…”

“…There are at least two reasons to expect that tax planning could reduce analysts' forecast accuracy. First, tax planning often necessitates that transactions and operations be structured in complex ways (e.g., Mills et al 1998;Balakrishnan et al 2019), and, in their review of the literature, Ramnath et al (2008) note that analyst forecast accuracy declines as firm complexity increases. In addition, other research indicates that analysts inadequately incorporate the effects of changes in tax regulations into their earnings per share (EPS) forecasts (Plumlee 2003).…”