[This study investigates whether accounting earnings of U.S. corporations are managed in response to changes in the statutory corporate income tax rate. The Tax Reform Act of 1986 (TRA) reduced the maximum corporate tax rate from 46 percent to 34 percent. If managers attempt to maximize firm value by minimizing tax costs, this tax rate change would have provided a substantial incentive to defer income. The motivation for this study comes from attempts by previous researchers to identify situations in which incentives to manage earnings exist and to find empirical evidence of such management (Healy 1985; DeAngelo 1986; Liberty and Zimmerman 1986; McNichols and Wilson 1988; Jones 1991; Cahan 1992). Evidence of earnings management is examined by focusing on accounting accruals. As pointed out by Manzon (1992) and Choi et al. (1991), total accruals can be separated into those types of accruals that are not expected to have a significant effect on taxable income (called "non-current accruals," e.g., depreciation) and those types of accruals that are expected to affect taxable income (called "current accruals," e.g., accounts receivable, accrued payables). By knowing exante which types of accruals are most likely to affect tax savings, more powerful tests of tax motivated earnings management are possible. Firms expected to reduce financial statement income to achieve tax savings are large firms, firms with low levels of long-term debt, and firms with high levels of manager ownership. While the reduction in corporate tax rates provided an incentive for managers to decrease financial statement income in the year prior to the effective date of TRA, other incentives might make it costly for managers to do so. For this reason, many firms may choose to forego a current tax savings to avoid reducing financial statement net income. The results of empirical tests report significantly lower current accruals for large firms for the year prior to the tax rate reduction.1 As predicted, these accruals are positively associated with levels of long-term debt. There is no relation between accruals and manager ownership. Accruals for large firms with years ending 30 June are not lower than those of calendar year firms. This study provides evidence of management of financial statement income in response to a large decrease in the statutory corporate tax rate. The results have implications for independent auditors, who face conflicting incentives to (1) provide clients with tax minimization advice, and (2) detect material cases of client earnings management. The results are also expected to be of interest to tax policy decision makers, since the ability of corporate managers to engage in tax rate arbitrage through earnings management can affect revenue estimates, as well as estimates of effects of tax law changes.]

Investigates whether accounting earnings of American corporations are managed in response to changes in the statutory corporate income tax rate brought about by the Tax Reform Act of 1986 (TRA). Reducing the maximum corporate tax rate from 46% to 34% through TRA; Concept of earnings management in relation to tax rate reductions in the TRA.

[Much of the research in positive accounting theory deals with whether managers choose accounting methods that reduce or minimize certain costs faced by firms, such as the cost of violating bond covenant restrictions, political costs, and the tax cost associated with the use of the FIFO rather than the LIFO inventory method. However, this research ignores some more fundamental costs associated with the legal form under which the firm chooses to operate, a much larger issue that precedes the choice of accounting methods. This article examines this larger issue by focusing on the trade-off that exists between tax costs and transaction costs in the choice of organizational form. Scholes and Wolfson (1986, 1989) assert that an organization's form is chosen to minimize both tax costs and transaction costs. Under this theory, if the corporate form has a greater tax cost than that of an alternative form, the partnership, the corporate form would not be chosen unless the transaction costs of the partnership form exceed those of the corporate form. Fama and Jensen (1983b, 327) examine costs of alternative organizational forms and state that "the form of organization that survives in an activity is the one that delivers the product demanded by customers at the lowest price while covering costs." Although Fama and Jensen specifically excluded tax costs from their analysis, Scholes and Wolfson argue that both relative tax costs and relative transaction costs are important determinants of organizational form choice, and that changes in relative tax costs will result in changes in form. They also make the following predictions about the effect of the 1986 Tax Reform Act: corporations will be replaced as an organizational form by partnerships for new ventures financed with equity; many existing corporations will convert to partnership form; absent this conversion, many corporations will add debt to their capital structure. These predictions lead directly to two questions. First, how do tax laws affect the choice of business entity? Second, what happens when these tax laws change? These two general questions are investigated here through two more specific research questions. The first is, What are the incremental tax costs and transaction costs of alternative organizational forms (corporations and master limited partnerships) available to large, publicly traded firms? The second is, How will managers of existing corporations respond to a tax law change (the 1981 Economic Recovery Tax Act) that causes the tax cost of the corporate form to increase relative to that of the partnership form? The results of empirical tests of four hypotheses developed to investigate these research questions indicate that, for the period 1978-85, the corporate form resulted in a significantly greater average tax cost than the partnership form, and this incremental tax cost increased significantly after the 1981 Economic Recovery Tax Act (ERTA). Partnerships are found to have a significantly lower return on assets and sales than a matched sample of corporations. Responses of managers to increasing tax costs of the corporate form after 1981 are predicted to be (1) increasing long-term debt, (2) increasing non-dividend distributions, and (3) decreasing dividend payout ratios. Empirical results for both univariate and multivariate tests are consistent with these predictions. These results make a significant contribution to accounting research for two reasons. First, they demonstrate a relationship between changes in relative tax costs of alternative (competing) organizational forms and changes in such fundamental elements of capital structure as debt levels, non-dividend distributions, and dividend payout ratios. Previous research on the relationship between taxes and capital structure (e.g., Bradley et al. 1984; DeAngelo and Masulis 1980; MacKie-Mason 1990; Titman and Wessles 1988) has not considered the effect of the tax cost of alternative organizational forms. Second, the results provide empirical support for predictions by Scholes and Wolfson (1986, 1989) and Petruzzi (1988) regarding responses of corporations to increases in relative tax costs (i.e., Scholes and Wolfson predict increasing long-term debt; Petruzzi predicts increasing non-dividend distributions).]

We investigate how shareholder taxes and risk preferences affect both a stock’s expected return, which reflects the capitalization of the dividend tax penalty into stock price, and the fraction of a firm’s stock held by tax-exempt investors. Our model demonstrates that the dividend tax capitalization effect reflects the weighted average tax rate of all investors, where the weighting depends on investors’ risk tolerances. This weighted average tax rate is not affected by the fraction of stock held by tax-exempt investors; however, tax-exempt investor ownership can be correlated with the weighted average tax rate if differences in tax-exempt investor ownership for different stocks reflect differences in investor risk tolerances for those stocks. Our empirical tests are consistent with the model’s predictions, and provide an equilibrium framework for interpreting prior empirical studies in accounting.

We investigate the relation between tax rates and pretax returns by showing how implicit tax, tax incidence, and tax capitalization change in response to a tax rate change. We examine these issues in the context of both financial assets and real investments made by corporations in a competitive equilibrium in which all investments earn the same after-tax rate of return. Results show that the pretax return increases in the statutory tax rate due to an explicit tax rate effect and decreases due to a cost of capital effect; the net effect is ambiguous. In contrast, the implicit tax rate is weakly increasing in the statutory tax rate. We also relate our findings to the empirical literature on the effects of taxes on pretax returns.

This study examines the effect on firm value of repealing the last-in, first-out (LIFO) inventory method for tax purposes. Our model extends prior literature by determining quantities and prices in equilibrium, rather than specifying them exogenously. We find that LIFO repeal could increase the future after-tax cash flows of firms that had used LIFO, because the higher tax costs associated with FIFO result in lower equilibrium quantities and higher equilibrium output prices, which increase pretax cash flows. We illustrate our model by examining inventory methods used by firms in the oil industry.

This paper compares two attributes of a deferred tax liability (DTL) that arise from differences in book and tax depreciation methods. The first attribute is the effect of the DTL on the market value of the firm. The second is the length of time between when the asset is placed into service and when the DTL associated with that asset begins to reverse. The paper shows that a decrease in the time it takes for the DTL to begin to reverse is neither necessary nor sufficient for the value of the DTL to increase. It also shows that the value of the DTL is not equal to the present value of the future deferred tax expense. The effect of one dollar of DTL on firm value depends only on the tax depreciation rate and the discount rate.

This study uses an analytical model to investigate the value of the firm when there are temporary differences between when revenue and expense items are recognized for tax- and financial-reporting purposes. The model shows that deferred tax assets and liabilities transform book values of underlying liabilities and assets into estimates of the after-tax cash flows on which the firm's market value is based. The analysis shows that if tax deductions are taken on a cash basis, and if the underlying assets and liabilities are recorded at the present value of their associated future cash flows, then the value of deferred tax assets and deferred tax liabilities is their recorded amount, regardless of when the asset will be realized or when the liability will reverse. If tax deductions are not taken when the expenditure is made (e.g., depreciation) or if underlying assets and liabilities are recorded at more than the present value of their associated future cash flows (e.g., warranty liabilities), then the market value of deferred tax assets and deferred tax liabilities is less than their recorded values. The value of the deferred tax account is independent of when that account will reverse.

We test whether tax avoidance strategies are associated with greater firm risk. We find that low tax rates tend to be more persistent than high tax rates and that measures of tax avoidance commonly used in the literature are generally not associated with either future tax rate volatility or future overall firm risk. Our evidence suggests that, on average, corporate tax avoidance is accomplished using strategies that are persistent and do not increase firm risk. We also find that the volatility of cash tax rates is associated with future stock volatility, suggesting that tax rate volatility and overall firm risk are related.

We provide evidence about allocations of cash flow freed up by not paying taxes (“tax-related cash”). Uncertainty about future repayments suggests firms may use tax-related cash more cautiously than other cash flow. We utilize a flow-of-funds model from finance to quantify the relative amounts of tax-related cash associated with various potential uses of operating cash flow. We find firms allocate tax-related cash differently than other after-tax cash flow. Prior studies find tax avoiders hold more cash, and our results suggest this is because firms invest less (and save more) tax-related cash. We also find that the allocation of tax-related cash varies with relative financial constraints, economic uncertainty, and firms' multinational status in ways consistent with prior findings. For example, firms facing relatively higher levels of financial constraints invest a lower (higher) percentage of tax-related cash in capital expenditures (marketable securities and R&D), possibly to preserve funds for future investment opportunities.