Corporate Tax Aggressiveness and the Role of Debt

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1 Corporate Tax Aggreivene and the Role of Debt Akankha Jalan, Jayant R. Kale, and Cotanza Meneghetti Abtract We examine the effect of leverage on corporate tax aggreivene. We derive the optimal level of aggreivene for a firm with a given level of debt in a two-date, ingle-period model in which a firm manager with an equity take in the firm maximize her payoff. The optimal level of heltering i determined by the tradeoff between the reduction in taxe from heltering and the increaed likelihood of bankruptcy that come from heltering. The model provide condition under which the optimal level of heltering i decreaing in the level of debt and increaing in the manager equity ownerhip. Conitent with our theory, we provide empirical evidence that level of heltering relate negatively with leverage and poitively with the firm CEO alignment incentive. We addre endogeneity concern by including firm fixed effect and analyzing the effect of a 2005 law change that enhanced creditor right in bankruptcy. Further, we how that the negative effect of debt on tax heltering i tronger for rikier firm; and weaker for larger, better governed, more profitable firm, and for firm that are in the public eye. We provide ome evidence that while leverage reduce heltering, it increae the proportion of income that i heltered. Finally, our analyi indicate that tax heltering reduce firm value. Thi verion: January 31, 2013 Correponding author: Jayant R. Kale. Jalan i at the Indian Intitute of Management, Bannerghatta Road, Bangalore , India; Kale i at the Department of Finance, J. Mack Robinon College of Buine, Georgia State Univerity, Atlanta, Georgia 30303; e- mail: Meneghetti i at the Department of Finance, Wet Virginia Univerity, Morgantown 26506; Kale acknowledge upport from the H. Talmage Dobb, Jr., Chair. We acknowledge the helpful comment from eminar participant at the Indian Intitute of Management Bangalore. We are reponible for all error

2 Corporate Tax Aggreivene and the Role of Debt Abtract We examine the effect of leverage on corporate tax aggreivene. We derive the optimal level of aggreivene for a firm with a given level of debt in a two-date, ingle-period model in which a firm manager with an equity take in the firm maximize her payoff. The optimal level of heltering i determined by the tradeoff between the reduction in taxe from heltering and the increaed likelihood of bankruptcy that come from heltering. The model provide condition under which the optimal level of heltering i decreaing in the level of debt and increaing in the manager equity ownerhip. Conitent with our theory, we provide empirical evidence that level of heltering relate negatively with leverage and poitively with the firm CEO alignment incentive. We addre endogeneity concern by including firm fixed effect and analyzing the effect of a 2005 law change that enhanced creditor right in bankruptcy. Further, we how that the negative effect of debt on tax heltering i tronger for rikier firm; and weaker for larger, better governed, more profitable firm, and for firm that are in the public eye. We provide ome evidence that while leverage reduce heltering, it increae the proportion of income that i heltered. Finally, our analyi indicate that tax heltering reduce firm value

3 Corporate Tax Aggreivene and the Role of Debt Any one may o arrange hi affair that hi taxe hall be a low a poible; he i not bound to chooe that pattern which will bet pay the Treaury; there i not even a patriotic duty to increae one' taxe. Judicial Opinion, Judge Learned Hand, Helvering v. Gregory, 69 F.2d 809, (2d Cir. 1934) Over and over again court have aid that there i nothing initer in o arranging one' affair a to keep taxe a low a poible. Everybody doe o, rich or poor; and all do right, for nobody owe any public duty to pay more than the law demand: taxe are enforced exaction, not voluntary contribution. Judicial Opinion, Judge Learned Hand, Commiioner v. Newman, 159 F2d 848 (1947) The incentive to avoid paying income taxe are undertandable ince more than a third of the firm profit can potentially be taken away by the State through taxe. Over the lat two decade, the tax department of U.S. corporation have become active profit center with annual target for effective tax rate and tax aving (Novack, 1998; Hollingworth, 2002; Clark, Martire, and Bartolomeo, 2000) and determining way to helter income in order to avoid taxe i, thu, their primary activity. Theoretical paper that derive a firm optimal level of income heltering (e.g., Slemrod, 2004; and Deai and Dharmapala, 2009)) typically conider an all-equity firm. Thee model offet the tax benefit of heltering with aumed expected cot of heltering. Sheltering activitie need not necearily be deemed illegal by regulatory authoritie and, therefore, the expected cot of heltering i determined by the probability of detection, the potential penaltie if found guilty, and the lo of reputation and pretige. We chooe an alternative approach by conidering a levered firm and propoe that a firm optimal level of heltering will depend on the level of debt in the firm. We ue the term tax aggreivene, heltering, and avoidance interchangeably and will define them later. There are everal way in which the preence of riky debt in the firm capital tructure can affect it ability to helter income. Firt and mot obviou i the fact that debt reduce taxable income and thereby may reduce the incentive to helter income. Second, ince the benefit of heltering do not accrue in bankruptcy, there are fewer tate in which the firm can helter. Third, creditor uch a bank and intitutional debtholder monitor firm activitie, which will reduce the ability of the firm to helter income. We derive the optimal level of heltering for a firm with a given level of debt in a imple twodate, ingle-period model in which a firm manager with an equity take in the firm maximize her payoff

4 The debt in the firm i riky and, therefore, bankruptcy i poible. We aume that bankruptcy i more cotly to the manager ince he bear additional peronal and poibly non-pecuniary cot if the firm goe bankrupt. Further, only the manager oberve the true cah flow and other oberve only the cah flow that i reported by the manager. Firt, we conider a etting where the manager i alo the owner of the firm and decide whether and how much of the pre-tax income to helter from taxe. We aume that the owner-manager mut determine ex ante the optimal amount to helter in the next period. Thi aumption i reaonable ince helter are ophiticated financial product and require coniderable time to materialize and generate benefit. Since the heltering deciion i made before cah flow are realized and outider, including debtholder, oberve only the reported cah flow that have already been reduced by heltering, heltering increae the number of tate in which the firm i bankrupt. Further, all heltering activitie are revealed if the firm goe bankrupt and all benefit from heltering are lot. 1 The optimal level of heltering i determined by the tradeoff between the reduction in taxe from heltering and the increaed likelihood of bankruptcy that come from heltering. We then conider the cae of a diverely owned firm in which the manager own an equity take. In thi etting, the manager can helter income from taxe to the benefit of all hareholder but can alo divert part of the heltered income for her ole ue. Since we aume that diverion happen only out of heltered income, on the one hand, the manager want to helter more in order to be able to divert more but, on the other hand, he mut helter only up to the point where the rik of bankruptcy i not too high. The optimal heltering level for the manager i thu a trade-off between her benefit in the form of tax aving and diverted income and the increaed likelihood of bankruptcy. In both the owner-manager and diverely owned firm, we how that the optimal level of heltering i decreaing in the level of debt a long a the increae in the likelihood of bankruptcy i 1 There are everal reaon to aume that it i difficult for the manager or the firm to retain the benefit of heltering in the tate of bankruptcy. Firt, in bankruptcy, all payment to the firm executive become ubject to the approval of the bankruptcy court. Further, ince the IRS i a enior claimant on the aet of the bankrupt firm, taxe hown to be evaded mut be returned to the IRS, i.e. there can be no waiver of uch due. Second, anecdotal evidence indicate that bankrupt or financially troubled firm (e.g., Enron) are ubjected to greater crutiny and it i likely that tax avoidance activitie will be revealed

5 ufficiently high. We alo how the optimal level of heltering in a levered firm i increaing in the manager equity ownerhip only a long a the increae in the likelihood of bankruptcy i not too high. We tet the prediction of our model on a large ample of U.S. firm over the period The finding from our empirical analyi are largely conitent with the prediction of our theory. We find trong evidence that leverage relate negatively with the level of tax heltering; and that it i increaing in the firm CEO alignment incentive. Thee finding are robut to alternative meaure of heltering and leverage and to the incluion of firm fixed effect to control for endogeneity ariing from time invariant unoberved variable. Our theoretical framework aign a crucial role to the likelihood of bankruptcy. In upport, we find that the negative effect of debt on tax heltering i amplified in rikier firm. The negative heltering-relation i weaker for larger, better governed, and more profitable firm a well a firm that are in the public eye. To how that baic finding are robut to correction for endogeneity ariing from time-varying unoberved variable, imultaneity of leverage and tax aggreivene, and revere cauality, we how that they hold in a quai-natural experiment uing change in the U.S. Bankruptcy Code in We alo preent finding that are conitent with indirect implication of our theory. In our theoretical framework, we aume that heltering increae the number of bankruptcy tate and thu a firm can obtain the benefit of heltering in fewer tate. Thi poibility may lead the firm to helter a larger proportion of it income. We find weak evidence that while leverage reduce heltering, it increae the proportion of income that i heltered. Finally, we preent ome finding on how tax heltering activitie affect firm value. Our analyi indicate that, in general, tax heltering activitie reduce firm value. The term tax heltering/avoidance/aggreivene that we ue interchangeably have pecific connotation in our etting. Hanlon and Heitzman (2010) define tax avoidance to be a continuum of activitie that enable corporation to reduce taxe. At one extreme of thi continuum are perfectly legal activitie uch a the purchae of tax-exempt bond, while at the other end, are egregiouly abuive taxaving tranaction uch a the ue of prohibited tax-helter product, tranfer mipricing etc., which will - 5 -

6 urely reult in fine and penaltie againt the firm if detected by the IRS. The activitie that we refer to a tax heltering/avoidance/aggreivene are between thee extreme. Thee activitie are generally baed on a weaker et of fact and are often undertaken after a rigorou reading of the tax law. Therefore, it i a priori not clear whether thee activitie will be deemed illegal or even detected. 2 The main contribution of our paper i to highlight the role of corporate leverage a a determinant of tax aggreivene. In addition to the examining the effect of the bankruptcy rik engendered by debt, we alo explicitly conider a manager incentive to divert a portion of the heltered income for peronal conumption. To the bet of our knowledge, there i no theoretical paper that conider both thee apect. Slemrod (2004) wa one of the firt theoretical paper to analyze the corporate tax avoidance deciion in an agency-theoretic framework but did not conider the role of debt. 3 Deai, Dyck and Zingale (2007) (DDZ) preent a theoretical framework to explain the cro-ectional variation in managerial diverion They model an all-equity firm and, thu, cannot offer inight into the effect of bankruptcy and hareholder-bondholder agency problem on tax aggreivene. The working paper by Joulfaian (2011) include debt in the analyi but ignore the hareholder-bondholder agency problem. Deai and Dharmapala (2009) analyze tax avoidance a a function of the efficacy of the firm corporate governance but do o only for the all-equity firm. Empirical tudie generally include leverage a a control variable in explaining the cro-ectional determinant of tax avoidance/ aggreivene and, therefore, there i only indirect evidence on how the preence of debt affect tax avoidance behavior. 4 Furthermore, the evidence i mixed. Gupta and 2 Corporate tax helter are example of tax aggreivene. The US Government Accountability Office define abuive tax helter a very complicated tranaction promoted to corporation and wealthy individual to exploit tax loophole and provide large, unintended tax benefit. The IRS detect uch a helter only after it ha been ued by many and ha reulted in ignificant reduction in tax collection. 3 Following Slemrod (2004), Chen and Chu (2005) tudy corporate tax evaion and how that when avoidance i cotly to the manager, the optimal wage contract of the principal-agent framework turn out to be inefficient. Crocker and Slemrod (2005) ue a cotly tate falification framework and demontrate that penaltie on tax evaion impoed directly on tax manager are more effective in curbing evaion that thoe on the firm. 4 A recent paper by Haan et al (2013), however, conider a omewhat different apect of the relation between leverage and tax avoidance. The tudy how that firm that have higher level of tax avoidance incur a higher cot for bank debt. While the negative effect of debt on tax avoidance that we how i not inconitent with the finding in Haan et al, our approach differ from their in important way. We propoe and empirically how that higher leverage reult in lower tax aggreivene wherea Haan et al implicitly aume the oppoite direction of cauality. While thee two approache are not mutually excluive, we believe that a firm capital tructure i likely - 6 -

7 Newberry (1997) and Rego and Wilon (2012) find that firm with high leverage ratio are aociated with lower effective tax rate, which i conitent with higher tax avoidance. Wilon (2009) and Liowky (2010), on the other hand, provide evidence that tax helter firm are aociated with lower leverage ratio. Our empirical finding add everal empirical inight to thi trand of literature. Firt, we provide trong evidence for a negative relation between tax heltering and leverage. Second, by howing that the negative leverage-heltering relation i weaker for high rik firm, we highlight the importance of bankruptcy conideration in determining the level of heltering. Our tudy alo contribute to the literature that examine the relationhip between corporate governance and tax avoidance. 5 Following Slemrod (2004), there have been a number of paper on the interaction of firm-level corporate governance with the deciion to avoid taxe (e.g., Deai and Dharmapala, 2006; Deai, Dyck and Zingale, 2007; Rego and Wilon, 2012; Armtrong et al, 2012). Citing example of firm uch a Enron, Parmalat, and Tyco, reearcher have argued that trong complementaritie exit between tax avoidance and managerial rent-eeking. The cot of indulging in one, reduce the cot of another (Deai, 2005; Deai and Dharmapala, 2006; Deai, Dyck and Zingale, 2007). Deai and Dharmapala (2009) addre the iue of whether tax avoidance activitie advance hareholder interet and argue that while tax avoidance may enhance hareholder value by aving tax outflow, uch aving may be offet by higher opportunitie for managerial diverion of the firm reource. They further ugget that better-governed firm are more likely to be able to retain the benefit of tax avoidance. Their empirical tet upport the hypothei that tax avoidance enhance firm value only in well-governed to be a long-term deciion wherea tax avoidance deciion will vary from period to period. In other word, it i more likely that manager decide on tax avoidance activitie taking the firm leverage a given. 5 The link between tax avoidance and corporate governance date back to the year 1909 when corporate income tax wa introduced in the U.S. One of the key reaon for introducing the new tax on corporate income wa to addre corporate governance iue. There wa concern that the corporation would not provide accurate financial information to hareholder a there wa a marked abence of effective corporate governance mechanim. Since tax return had to be filed with on a regular bai, verification of the firm true income became much eaier (at that time, tax return were public document). Preident William Taft, in hi June 16, 1909 peech on the introduction of corporate taxation aid Another merit of thi tax (the federal corporate excie tax) i the federal uperviion which mut be exercied in order to make the law effective over the annual account and buine tranaction of all corporation. While the faculty of auming a corporate form ha been of the utmot utility in the buine world, it i alo true that ubtantially all of the abue and all of the evil which have aroued the public to the neceity of reform were made poible by the ue of thi very faculty. If now, by a perfectly legitimate and effective ytem of taxation, we are incidentally able to poe the Government and the tockholder and the public of the knowledge of the real buine tranaction and the gain and profit of every corporation in the country, we have made a long tep toward that uperviory control of corporation which may prevent a further abue of power

8 firm. Thi i conitent with Wilon (2009) who find that the benefit of engaging in tax helter accrue to hareholder of well-governed firm only. Some reearcher propoe that firm, like individual, differ in their preference for undertaking riky tax avoidance and have treed the need for identification of determinant of tax avoidance (Slemrod, 2004; Hanlon and Heitzman, 2010). Our tudy contribute to thi literature by highlighting the role of leverage a an important determinant of tax aggreive behavior. Our finding on the relation between managerial equity ownerhip on tax heltering add to the literature by highlighting the importance of debt in thi relationhip. Deai and Dharmapala (2006) tudy find that higher incentive compenation reduce tax avoidance and that thi relationhip i driven primarily by poorly-governed firm. Thi i in contrat to Hanlon, Mill, and Slemrod (2005) and Rego and Wilon (2012) who find a poitive aociation between equity rik incentive and tax aggreivene, but find no variation by firm-level corporate governance. Armtrong et al (2012) provide evidence that CEO equity rik incentive are poitively aociated with tax avoidance primarily in the right tail of the tax avoidance ditribution. Our finding add to thi literature by howing that the negative leverageheltering relation i weaker when the CEO ha greater alignment incentive and, furthermore, alignment incentive have no effect on heltering in the abence of debt. Finally, our finding alo add to the literature on the role of debt a a monitoring mechanim. Debt help dicipline management becaue default allow creditor the right to force the firm into bankruptcy (Harri and Raviv, 1990). Debt contract uually contain detailed covenant and other retriction that limit managerial flexibility in mot operating deciion. Cremer et al (2007) how that bond-holder and equity-holder conflict are mitigated through bond covenant. Studie alo how that bankruptcy i cotly to the firm (Ang, Chua and McConnell, 1982; Lawle and Ferri, 1997; Altman, 1984; Altman and Hotchki, 2006), but it i cotlier to the manager becaue he bear non-pecuniary cot (Gilon, 1989; Gilon and Vetuypen, 1993; Hotchki, 1995; Betker, 1995; Ayotte and Morrion, 2007). There are alo many paper that examine the monitoring role of debt and debtholder involvement in firm governance (Gilon, 1989; Gilon and Vetyupen, 1993; Krozner and Strahan, 2001; Byrd and - 8 -

9 Mizruchi, 2005; and Nini et al, 2012). Our finding that the preence of debt i aociated with lower level of tax heltering identifie another apect of the monitoring role of debt. The article i organied a follow: Section 1 preent the model, Section 2 dicue the data ource, Section 3 preent univariate tatitic, Section 4 ummarize empirical reult, and Section 6 offer ome concluding remark. 1. The model Conider an all-equity firm that ha acce to an invetment opportunity requiring an invetment of I at time t = 0, which we aume mut be raied through debt with face value D. The debt mut be repaid at time t = 1 when the payoff from the invetment are realized and the firm end. The tochatic payoff from inveting I i y, which ha a cumulative ditribution function F(.) and a denity function f(.). We aume that the true payoff i obervable to the manager alone. 6 Debt i riky ince the payoff y may not be ufficient to repay the debt in full. 7 All agent are rik neutral and the rik-free rate i zero. The preence of corporate taxe reduce the payoff to equity, which create incentive to helter ome part of the firm taxable income. We aume that there are no direct cot to heltering income except, a we explain hortly, heltering increae the probability of bankruptcy; and all heltering benefit are lot if the firm goe bankrupt. 8 Let denote the dollar amount to be heltered at time t = 1 and aume that it i determined by the manager in t = 0 baed on her expectation of the future cah flow y and the probability of bankruptcy. Once the payoff y i realized in t = 1, the manager helter the amount and ue the remaining cah flow y to pay back the debt-holder. In other word, the firm goe bankrupt if and only if y D. 9 Note that ince only y i available for paying bondholder, heltering increae the number of tate in which the firm i bankrupt. A we will how hortly, we do 6 Thi i an important aumption ince, without it, the manager will not have the incentive to avoid taxe and divert fund for peronal conumption becaue thee activitie will be detected. Thi aumption i common in model of agency (Groman and Hart, 1982) and the literature on tax avoidance (Deai and Dharmapala, 2006; Deai, Dyck and Zingale, 2007; and Crocker and Slemrod, 2005). 7 For implicity and given the ingle-period framework, we aume that default lead to bankruptcy and necearily implie liquidation under Chapter 7 of the U.S. Bankruptcy Code and Chapter 11 reorganization i not reaonable. 8 The cae can be extended to include direct cot of heltering including the probability of detection and penaltie. 9 We note here that our reult go through if we define a a proportion of y

10 not explicitly model the (peronal and non-pecuniary) cot that the manager bear in bankruptcy, but our framework implie that the manager trie to avoid bankruptcy. In the above imple framework, we analyze two cae. In the firt cae, the manager i alo the owner of the firm and, therefore, he ha the incentive to helter income from taxe but not to divert cah flow for perquiite conumption. In the econd etting, there i eparation between firm ownerhip and control the firm ownerhip i diffue and the manager own a fraction of the firm equity. In thi cae, the manager may helter income from taxe a well a divert a portion of the heltered income for perquiite conumption The owner-manager cae In the etting of an owner-manager firm, the manager i not able to recover the proceed from her heltering activitie in cae of bankruptcy. The lo of heltering proceed in bankruptcy impoe a cot on heltering a heltering increae the number of tate in which the firm goe bankrupt and heltering benefit are lot. In other word, the benefit of heltering exit only in the non-bankruptcy tate. 10 At t = 0 the owner-manager chooe the level of heltering that maximize her payoff. We have aumed that the level of debt in the firm D i exogenouly given. A more general etting would have both and D a the manager choice. We have conidered thi poibility and find that including the debt level a a choice ignificantly increae analytical complexity without changing the prediction regarding heltering. Therefore, we preent the imple cae where the manager need to chooe only the heltering level. max 0 V OM [( y D)(1 t) ][1 F( D)] (1) Equation (1) implie that the manager receive a payoff only when the firm i not bankrupt and thi payoff conit of the after-tax value of equity (y D)(1 t) and, the entire proceed from 10 In view of the greater crutiny into financial tranaction of firm that file for bankruptcy, thi aumption i reaonable. There i anecdotal evidence (Enron and Tyco) that tax avoidance activitie of financial troubled corporation are revealed due to increaed invetigation. After the initiation of the bankruptcy proce, the IRS i a claimant on the aet of the firm. Further, taxe that can be hown to be evaded can alo be recovered in full

11 heltering. For computational implicity, we allow for tax hield on the entire amount of debt D, rather than on the interet component only. In unreported reult, we confirm that our reult go through when we aume that only the interet i tax deductible. The firt-order condition for the optimal level of heltering i t h( D)[( y D)(1 t) t ]. (2) In equation (2), h( D) f ( D)/[1 F( d)] i the hazard rate. In the context of our model, the hazard rate repreent the increae in the probability of firm bankruptcy for a $1 increae in tax heltering, conditional on the fact that the firm i preently olvent. To enure that the i a maximum, we aume that h' ( D) The left hand ide of the firt-order condition repreent the tax aving obtained by heltering an extra dollar. The right hand ide capture the expected cot of heltering, which i the expected lo of heltering benefit from the additional dollar of heltering. Our objective i to determine the relation between debt level and tax aggreivene a meaured by. The preence of riky debt in the capital tructure can reduce or increae the level of heltering and we how that the direction of the relation depend on how increaing heltering affect the probability of bankruptcy. Since debt reduce the number of (non-bankruptcy) tate in which the owner-manager can benefit from heltering, the manager ha the incentive to helter more in the non-bankrupt tate, which ugget a poitive relation between debt and. Alternatively, ince higher debt alo implie greater tax hield and all heltering benefit are lot in bankruptcy, higher leverage hould reduce the manager incentive to reort to cotly tax avoidance activitie (Graham and Tucker, 2006). In the above maximization problem, the level of debt D i exogenou. Then, auming that i an interior optimum, the firt-order condition can be repreented a G (, D) = 0, where G (, D) i an implicit function of the optimal level of heltering and D. Applying the Implicit Function Theorem lead to the following propoition on the relation between optimal level of heltering and the debt level. (All proof are in Appendix A): 11 The aumption of an increaing hazard rate i atified for a hot of ditribution uch a the uniform, exponential, the gamma and Weibull with degree of freedom parameter le than 1 (Groman and Hart, 1982)

12 Propoition 1: The relation between the optimal level of heltering and the debt level D i negative if and only if h'( D)[( y D)(1 t) t ] 0 and h'( h( D) D) 1 t [( y D)(1 t) t. ] The term h'( D) / h( D), which i the derivative of the natural log of h( + D), repreent the relative change in h(.). Intuitively, the condition implie that the relation between the debt level and the optimal level of heltering i negative if the marginal effect of an extra dollar of heltering on the likelihood of bankruptcy (the hazard rate) i ufficiently large. In other word, given the aumption of increaing hazard rate, if the hazard rate increae fat enough, the leverage-heltering relation i negative. The condition alo implie that leverage i effective in reducing tax aggreivene only when the manager perceived probability of the firm going bankrupt, captured by the term h'( D) / h( D), i ignificantly high. The empirical evidence that we preent later in the paper conitently indicate that the relation between debt level and tax heltering i indeed negative The cae when ownerhip and control are eparate We now aume that the manager i a hareholder in the firm and own a fraction λ, 0 < λ < 1, of the equity of the firm. While the manager interet are partly aligned with hareholder, the manager now ha the opportunity and the incentive to divert a part of the heltered income to her peronal advantage and hare only the remaining heltered income with the outide hareholder. We aume that diverion take place out of only the heltered income. 12 Let k, 0 < k < 1, be the fraction of heltered income that the manager chooe to divert. Unlike the owner-manager cae, now we alo aume that the manager incur a non-monetary cot B, B > 0, in cae the firm goe bankrupt. Both k and B are exogenouly given and contant. 13 The aumption of a fixed bankruptcy cot B to the manager i for computational implicity. We obtain qualitatively imilar reult when, a in Deai, Dyck and Zingale (2007), we include a penalty on tax heltering. 12 Our aumption i different from that in Deai, Dyck and Zingale (2007), who allow for the poibility of diverion out of the true payoff, which alo ha the effect of reducing taxable income. 13 The proportion of diverion, k, hould alo be optimally choen by the manager. However, our focu i on the relation between heltering and leverage. However, we will examine how the optimal level of heltering relate to change in k

13 In the above etting, the manager chooe the which maximize the following: max 0 V M { [( y D)(1 t) (1 k)] k}[1 F( D)] BF ( D) (3) The firt order condition i given by ( t k) k h( D){ [( y D)(1 t) (1 k)] k} h( D) B (4) The left hand ide of the equation (4) i the marginal benefit of heltering a dollar of income. Since heltering alo enable the manager to divert income, the marginal benefit i given by her hare in the aving in taxe le the amount diverted plu the entire amount diverted, which i not hared with the other hareholder. The right hand ide i the marginal cot of heltering an additional dollar of income. Increaing heltering increae the probability of bankruptcy in which the manager not only rik loing what he could have earned in the non-bankrupt tate, but he alo incur the non-pecuniary cot B. Again, uing the firt-order condition to define the implicit function G (, D), etting it equal to zero, and uing the Implicit Function theorem we analyze the relation between the optimal level of heltering and the debt level D in Propoition 2 (proof in Appendix A): Propoition 2: The relation between the optimal level of heltering and the debt level D i negative if and only if h'( D) h( D) (1 t) [ {( y D)(1 t) (1 k)} k B]. The interpretation of the condition in the above propoition i imilar to that in Propoition 1. The next propoition etablihe the relation between and the manager hare in the firm equity. The proof i in Appendix A. Propoition 3: The relation between the optimal level of heltering and the manager hare in the firm equity λ i poitive if and only if h D) [( y t k D)(1 t) ( (1 k)] Intuitively, one would expect the relation between the level of heltering and manager hare in equity to be poitive ince a higher hare in ownerhip reult in better alignment of the manager and

14 hareholder interet, giving the manager incentive to enhance firm value by reducing total tax outflow. The propoition above how that the poitive relation hold only if the hazard rate i not too high. If the likelihood of bankruptcy i ufficiently high, he would till chooe not to avoid taxe aggreively, depite high alignment of interet. In the following ection, we tet ome of the model implication on a dataet of US firm. 2. Sample and variable decription 2.1. Sample decription Our initial ample conit of all U.S. firm lited in Computat for the period We obtain data on executive compenation from Execucomp and on intitutional ownerhip from CDA/Spectrum. We exclude financial firm and utilitie (SIC code and , repectively) from the ample. Our main ample conit of 66,198 firm-year (9,648 unique firm) over the period The ubample which include the executive compenation variable conit of 16,621 firm-year obervation and i available for the period Detailed definition of all variable are in Appendix B Tax aggreivene meaure We define two variable to capture a firm tax aggreivene. Firt, we ue a meaure uggeted by Manzon and Pleko (2002) that attempt to capture the difference between the income a firm report to it hareholder baed on Generally Accepted Accounting Principle (GAAP) and the one it report to the income tax authoritie baed on tax law. Since income reported to tax authoritie i not directly obervable, it i imputed by dividing the tax expene reported by the firm in it financial tatement by the top tatutory corporate tax rate. Uing 35% a the top tatutory tax rate we compute the difference between the dometic pre-tax financial income and the imputed taxable income a Unadjuted Spread PI - PIFO - TXFED/

15 where the firt two term are pre-tax income and foreign pre-tax income, repectively, and TXFED i the amount paid in federal taxe for the year. Next we account for inherent difference between book and tax accounting that do not repreent tax aggreive activitie, and compute the variable Adjuted Spread Unadjuted Spread -TXS -TXO - ESUB where TXS repreent tate income taxe, TXO other income taxe, and ESUB meaure unremitted earning in non-conolidated ubidiarie. The three item ubtracted from Unadjuted Spread are either included in book income and not in tax income or vice-vera and, therefore, can affect the gap for reaon unrelated to tax aggreivene. Finally, we define our main tax aggreivene variable a Book Tax Gap Adjuted Spread / AT where AT repreent the firm total aet. 14 In order to avoid including firm with tax loe, which may have very different tax aggreivene incentive compared to firm with a poitive tax liability during the year, we only keep in the ample firm that report a poitive current tax expene in a given year (Deai and Dharmapala, 2006). Our econd meaure of tax aggreivene i deigned to capture the percentage of a firm true income that i heltered. For thi purpoe, we compute the ratio Unadjuted Spread to pre-tax book income (PI in Computat), and the ratio of Adjuted Spread to pre-tax book income Variable to meaure firm leverage and firm value The main variable of interet are a firm leverage and value. We define Leverage a the book value of debt divided by the book value of aet minu the book value of common equity plu the market 14 Book Tax Gap ha been widely ued and interpreted a evidence of tax avoidance/ heltering behavior (Mill, 1998; Deai, 2003, 2005; Manzon and Pleko, 2001; Mill, Newberry and Trautman, 2002). Similarly, the U.S. Department of Treaury White Paper titled The Problem of Corporate Tax Shelter (1999) identified large and increaing book-tax gap and interpreted them a evidence uggeting the increaed ue of tax helter by corporation. 15 The denominator in thi meaure i a noiy meaure of the true pre-tax income ince it i already reduced by what the manager ha managed to divert.there are everal reaon for uch noie. Firt, a firm taxable income i not directly obervable. Second, etimating it by groing up the reported tax expene ignore the tax impact of the exercie of non-qualified tock option (ESOP), reulting in an overetimation of imputed taxable income. Thi i made wore given the fact that tax deduction ariing out of tock option exercie are ignificant. For detail on meaurement error ariing out of etimating taxable income out of financial tatement data, ee McGill and Outlay (2002, 2004) and Hanlon (2003)

16 value of equity. We meaure the firm value with Tobin q, computed a book value of debt plu market value of common equity divided by book value of aet Control variable In our multivariate analyi, we control for a variety of firm characteritic. Size i the firm total book aet, while Profitability i a dummy that take a value of 1 if the firm report a poitive dometic pre-tax book income for the year. We include the variable ROA Volatility to capture the rik aociated with a firm profitability, and compute it a the tandard deviation of the firm return on aet for the previou ix year with a minimum of three obervation. Our meaure of tax aggreivene, Book Tax Gap, could be affected by earning management on the part of manager. Any upward moothing of income could reult in overtatement of our meaure. In order to control for thi effect we include in our analyi the variable Total Accrual, computed a in Bergtreer and Phillipon (2006) (ee Appendix B). 16 Following Manzon and Pleko (2002) we alo include a control variable the lagged Book Tax Gap, the pre and pot 1993 value for goodwill, annual Sale Growth, the abolute value of the firm foreign income, a dummy for Net Operating Loe (NOL), change in NOL carry-forward, change in pot-retirement obligation and the ratio of net to gro property, plant and equipment and total aet. In order to tet whether tax aggreivene i aociated with aet opacity we include the variable Intangible, which i the dollar value of the firm intangible caled by total aet. Since extant literature how that firm that report high R&D expene helter more income from taxe and et up more tax haven operation (Deai, Foley and Hine, 2006), we alo include the variable R&D, meaured a the ratio of R&D expene to total aet. Hanlon and Slemrod (2009) and Autin and Wilon (2013) argue that tax avoidance activitie have a reputational cot. In order to capture potential reputational cot of tax aggreivene ariing out of being in public glare, we include the variable Advertiing, computed a the ratio of advertiing expene 16 If we ue dicretionary accrual (Jone, 1991), the (unreported) reult do not change ignificantly,

17 to total aet. We alo capture a firm pretige with the variable Fort500 Dummy, which take a value of 1 for firm in the Fortune 500 lit, and zero otherwie (Meneghetti and William, 2013). Our main variable for firm governance i %Intitution, meaured a the percentage of the firm outtanding hare held by intitutional invetor uing the 13F filing data from the CDA/Spectrum databae. Finally, in order to capture the manager incentive alignment with the firm hareholder we compute the variable Stock Option Ratio, defined a the ratio of the Black-Schole value of tock option granted to the CEO and the um of her alary, bonu and tock option Decriptive tatitic Table 1 report the decriptive tatitic for the whole ample. The main independent variable, Book Tax Gap, ha a mean of and a median of The average firm in our ample ha a leverage of 15.9% and total aet of $1.234 billion. The ize variable i kewed, o in the multivariate analyi we ue the natural logarithm of firm ize. Table 2 preent the correlation matrix for the main regreion variable. The relation between Book Tax Gap and Leverage i weakly poitive at Column 1 ugget that firm with high intitutional holding, large ize, lower ROA volatility, higher total accrual, high intangible, low R&D and advertiing expenditure and high tock option ratio have larger book-tax gap. 4. Leverage and tax aggreivene In thi ection we examine the relation between Leverage and tax aggreivene in a multivariate etting. We firt etimate the baeline model where we regre Book Tax Gap on Leverage and the control variable on the full ample of 66,198 firm-year. We then control for the effect of CEO alignment and include the variable Stock Option Ratio in the bae regreion. Given the limited data availability on managerial compenation in the Execucomp databae, the ample ize reduce to 16,621. We then 17 Another poible meaure of managerial incentive alignment could be managerial ownerhip in the firm. However, Morck, Shleifer and Vihny (1988) argue that uch a meaure could alo capture managerial entrenchment which would reduce, rather than enhance the manager alignment with hareholder. Further, there i little timeerie variation in the ownerhip meaure. Therefore, we focu our attention only on the tock option ratio. 18 Thee number are conitent with Deai and Dharmapala (2009). Their meaure of tax gap i, however, what in thi paper we call Unadjuted Spread and i computed a imple difference between dometic pre-tax book income and inferred taxable income, without making any adjutment for earning in ubidiarie and tate income taxe. Alo, their ample ize i 4,492, while our i 66,

18 invetigate whether the relation between leverage and tax aggreivene varie acro firm with high leverage, intitutional holding, ize, ROA volatility, accrual, intangible, and advertiing expene. Then we preent reult uing a law change that affected the payoff to debtholder in bankruptcy a a quai-natural experiment that affected the monitoring incentive of bondholder. Next, we meaure tax aggreivene a the proportion of the true income that i heltered by the manager and regre it on leverage and the control variable. Finally, we preent our finding on the effect of leverage, tax aggreivene, and managerial alignment on firm value. Depending on the pecification, we ue firm a well a indutry fixed effect. For indutry fixed effect, we define indutry dummie at the 2-digit SIC code level. In all regreion tandard error are robut to heterocedaticity and are clutered by firm Baeline Leverage Book Tax Gap relation We firt etimate the regreion of the Book Tax Gap on Leverage and other control variable, which will hed light on the effect of leverage on the firm tax aggreivene (propoition 1 and 2). We preent the reult from thi analyi in Table 3. In Table 3, column one and two preent finding with indutry fixed effect (IFE) and firm fixed effect (FFE), repectively. In column three (IFE) and four (FFE), we preent the reult after including a dummy variable for high leverage firm. The main reult from thi table i that the coefficient on Leverage i negative and ignificant at the 1% level acro all column indicating that higher leverage i aociated with lower tax aggreivene. To gain a perpective on the ignificance of the effect of Leverage on tax heltering, we note that if the debt level increae from the 25 th percentile to the 75 th percentile value, the Book Tax Gap decreae by 31.56%. When we include the High Leverage Dummy in column three and four, the coefficient on Leverage remain negative and ignificant. Furthermore, the coefficient on the High Leverage Dummy i alo ignificantly negative, which further upport the negative relation between debt level and tax aggreivene. The coefficient on %Intitution i alway negative and ignificant, uggeting that higher intitutional ownerhip, contrued to indicate better governance, deter tax aggreivene. Thi reinforce the finding that tax aggreivene may not necearily be a value-enhancing activity for hareholder

19 (Deai and Dharmapala, 2009). The coefficient on Log(Size) i poitive and ignificant, which i conitent with the intuition that large firm face a lower rik of bankruptcy a compared to maller firm with imilar debt ratio. The intuition underlying the poitive coefficient on the Profitability Dummy i imilar to that for firm ize; however, we note that only firm that are profitable will need to helter income. The negative coefficient on ROA Volatility ugget, in the framework of our model, that ince firm with rikier cah flow are more likely to default, manager of uch firm may chooe to keep tax aggreivene low to avoid the rik of going bankrupt, which i peronally cotly to them. The coefficient on Advertiing i negative and ignificant in all pecification. Thi reult i conitent with the intuition that manager of firm that are in the public glare have more to loe in term of pretige and reputation and care more about the potential peronal cot of tax aggreivene (Hanlon and Slemrod, 2009). Similarly, the negative coefficient on Fort500 Dummy, our meaure of firm pretige, ugget that firm that have more to loe in term of reputation engage le in tax aggreive activitie Tax aggreivene and CEO incentive alignment We next tet examine how the negative relation between leverage and tax aggreivene varie with how well the CEO incentive are aligned with thoe of the hareholder. We expect that when the CEO incentive are better aligned, they are more likely to helter income from taxe ince their hare in the benefit of heltering i increaing in their alignment incentive. We preent the finding from thi analyi in Table 4. In the etimation in Table 4, we add the variable Stock Option Ratio and the interaction Stock Option Ratio Leverage to the pecification in column one and two in Table 3. The coefficient on Stock Option Ratio will indicate the relation of managerial incentive on tax aggreivene and that on the interaction term will indicate whether the effect of Leverage on tax aggreivene differ acro different level of CEO incentive alignment. While all the pecification include the Manzon- Pleko control, we do not report their coefficient for brevity. The reult in column one and two of Table 4 how that the negative relation between Leverage and Book Tax Gap continue to hold even after controlling for CEO alignment. The coefficient on Stock

20 Option Ratio i poitive and ignificant indicating that manager with a higher equity take in the company are more tax aggreive. When the pecification alo include the interaction term Stock Option Ratio Leverage, the coefficient on Stock Option Ratio i inignificant and that on the interaction term i ignificantly poitive. Thi finding highlight an intereting apect of the relation between tax aggreivene and CEO alignment incentive; if there i no debt in the firm, manager do not have the incentive to helter income. The poitive coefficient on the interaction term then ugget that alignment incentive lead to greater tax aggreivene only in the preence of debt. Another interpretation that i not mutually excluive i that the negative effect of Leverage on tax aggreivene become ignificantly le negative when CEO alignment i high. Viewed together, our finding indicate that debt and alignment incentive have oppoing/offetting effect on tax aggreivene and, therefore, it i important to control for the joint effect (e.g., with the interaction term) of thee two variable in empirical tet Leverage and tax aggreivene: Cro-ectional analyi We next invetigate whether the negative relation between firm leverage and tax aggreivene hold acro high and low value of ROA Volatility, Profitability, intitutional ownerhip, firm ize, incluion in Fortune 500 lit, Advertiing, Total Accrual, and CEO incentive compenation. In each tet, we create a dummy variable equal to 1 when the value of the variable of interet i above the median, and zero otherwie (for advertiing expenditure, the dummy take a value of 1 for poitive value). We then compute the interaction term LeverageDummy, and etimate the pecification from Table 3 (column two) with the dummy variable and the interaction term in the regreion. We preent our finding in Table 5. The table report the coefficient and t-tatitic only for Leverage, Dummy, and Leverage Dummy; we omit reporting the coefficient on other variable in the regreion the reult for brevity. In column one of Table 5, the variable Dummy repreent firm with greater buine rik a meaured by ROA Volatility; and the reult offer upport for the appropriatene of our theoretical framework. When there i debt in the capital tructure, greater buine rik implie greater likelihood of bankruptcy which, according to our theoretical framework, would mean greater cot to the CEO of heltering income. Thu the negative effect of Leverage on tax aggreivene will be amplified when the

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