Jeffrey L. Hoopes, Devan Mescall, and Jeffrey A. Pittman
Do IRS audits deter corporate tax avoidance?
The Accounting Review | Volume 87, Issue 5 (Sep 2012), 1603–1639

Corporations maximize profits. Since these profits are after-tax, corporations are often eager to invest in tax planning to lower their tax burden. This planning routinely takes the form of reducing the firm's tax liabilities through strategies that are clearly acceptable to tax authorities. In other cases, firms may become more aggressive and engage in tax avoidance strategies involving greyer areas of tax law where tax authorities are likely to disagree with the taxpayer's position. The Internal Revenue Service (IRS) attempts to deter any overly aggressive tax behavior of firms through audit and the threat of audit. An audit by the IRS is costly to firms because it may result in additional tax liability, interest and penalties, the cost of legal defense, and potential reputational costs of being labeled tax aggressive. Given these potential costs, our study investigates whether the likelihood of an IRS audit affects public firms' decisions on whether to undertake aggressive tax positions.

Pay more taxes or spend more to avoid taxes?

Although this may appear intuitive, there are a number of reasons to believe that corporate tax avoidance is insensitive to IRS oversight. For example, managers may discount the cost of an IRS audit when they consider their tax position to be highly defensible. Prior research by Hanlon-Mills-Slemrod (Book, 2007) document that of the firms audited in their sample, 45 percent had no proposed tax deficiency, and of those firms with a proposed deficiency identified by the IRS, only 60 percent of these amounts were later paid, suggesting that even when audits do occur, sometimes they are not very costly to firms.

In addition, it is possible that corporations behave like wealthy individuals by increasing tax avoidance when IRS monitoring is stricter to ensure that their after-audit tax liability remains stable. This was the finding of Slemrod-Blumenthal-Christian (JPubE 2001) and is explained further in a recent report by PricewaterhouseCoopers (2004, 6) that states:“...[T]he final agreement of a tax return often ends in a “horse trade” between the taxpayer and the relevant revenue authority; it may make sense to have a number of aggressive positions in the return so that there is something to give as part of any negotiations.” In other words, it may make sense for companies to undertake more aggressive positions to provide negotiating room when they perceive that an IRS audit is more likely, undermining the deterrence role of an audit. Considering these previously documented outcomes, it is an empirical question whether an increased likelihood of an IRS audit deters tax avoidance by corporations.

About 60% of firms would be deterred, 40% would not

To gain some initial insight into the relationship between tax enforcement and corporate tax avoidance, we surveyed members of the Tax Executive Institute (TEI) with multinational operations and received responses from 50 tax directors. Participants were asked, “From your experience, does a company's assessment of a higher probability of tax authority audit lead the company to...”, and were then given several options for finishing the sentence. The majority of respondents (59%) finished the sentence by saying that companies would “take a less aggressive tax position due to the risk of being challenged.” However, the rest (41%) replied that it would either “have no effect on the tax position taken”, or “take a more aggressive tax position for expected bargaining purposes.” In short, although the majority of respondents indicated that threat of audit would have a deterrent effect on corporate tax avoidance, a large fraction of respondents indicate that their companies do not become less tax aggressive when enforcement is stricter.

Statistical analysis with a larger data set confirms the deterrence effect

To investigate if the deterrent effect suggested by a majority of survey respondents generalizes to a larger population of public firms and holds on average, we use publicly available data from companies' financial statements for 10,626 unique firms over a 17-year span resulting in a total sample of 66,310 firm/year observations. We use data from this sample to estimate the following model of tax avoidance using ordinary least squares regression (subscripts are suppressed): CASH – ETR = β0 + β1 · AUDIT – PROBABILITY + β2 · X + V(1)

To measure tax avoidance we use the firms' cash effective tax rate (CASH – ETR), which is the amount of cash taxes paid by the firm divided by its pre-tax income. To measure IRS monitoring (AUDIT – PROBABILITY), we rely on data from the Transactional Records Clearinghouse (TRAC). This data provides details of how many corporations of a given size the IRS actually audits in a given year. X represents a set of control variables, including year and industry fixed effects.

Our analysis ranges from the earliest (1992) to the latest (2008) year that IRS audit rate data are available. Analyzing this long time-frame is constructive for identification since corporate tax enforcement was ascending at some points during this period and descending at others. Figure 1 shows that these fluctuations were different for companies of different sizes.

1: Time series of IRS audit rates
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There was not only a secular decline in audit rates, but also year-to-year variations in this decline across different types of firms.

In order to attempt to isolate the effect of IRS enforcement in the AUDIT – PROBABILITY measure, the model controls for other influences on tax avoidance, including the industry of the firm, year, size, leverage, capital expenditures, research and development expenditures, profitability, the presence of, and changes in, tax loss carry-forwards, foreign income, and the presence of a Big Four auditor.

When we estimate the model we find that as the likelihood of an IRS audit increases (AUDIT – PROBABILITY), firms avoid fewer taxes (CASH – ETR), providing evidence that greater IRS monitoring decreases corporate tax avoidance. Since our main measure of IRS audit rates are based on the TRAC data which is aggregated by firm size and time and not firm-specific, we also try several other measures of AUDIT – PROBABILITY to triangulate our results. We also try different measures of tax avoidance. Finally, we conduct a host of robustness tests to provide assurance that what we are observing in the data is all consistent with more IRS enforcement decreasing corporate tax avoidance. All of our robustness tests support our main finding.

Our results suggest that firms' cash effective tax rates rise by almost 2 percentage points (a 7 percent increase in relative terms) when the probability that the firm will be subject to an IRS audit increases from 19 percent (the 25th percentile in our data) to 37 percent (the 75th percentile). Put another way, the biggest group of companies in our sample, those with assets of $250 million or more, had a 27% probability of being audited in 2008, the last year covered in our study. If the likelihood of audit been 34%, as it was six years earlier, the results from our paper imply that the Treasury may have collected an extra $7.1 billion in 2008. In additional analysis, we find that the impact of IRS audit rates on corporate tax avoidance is larger in poorly-governed firms.

Collectively, our research suggests that higher levels of IRS enforcement increases the amount corporations pay in taxes. However, this does not necessarily mean that simply increasing IRS enforcement levels across all firms is desirable. Since tax enforcement consumes real resources the best enforcement policy must consider the net benefit and not just the policy that would result in corporations paying the most tax. Our results suggest that the effectiveness of tax authority monitoring on curbing tax aggressiveness can vary by firm specific factors such as governance. The best policy for corporate tax enforcement likely entails a combined approach including considering adjustments to enforcement levels for targeted firms, promoting cooperation between taxpayers and the IRS, considering requiring more corporate tax disclosure, and adjusting the penalty for committing tax evasion.

 

 

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