Investment, Tax Uncertainty, and Aggressive Tax Avoidance

Investment, Tax Uncertainty, and Aggressive Tax Avoidance Jennifer L. Blouin University of Pennsylvania Michael Devereux Oxford University Douglas A. Shackelford University of North Carolina June 2012 PRELIMINARY AND INCOMPLETE. PLEASE DO NOT CITE WITHOUT THE AUTHORS PERMISSION ABSTRACT This paper examines how tax uncertainty created by highly aggressive tax planning affects a firm s investment decisions. The tax uncertainty that we study arises from tax choices of such inadequate merit that the firms themselves believe that they will lose if audited. Consistent with a simple model that we develop, we find that investments in fixed assets and research and development are increasing, at a decreasing rate, in the tax savings from these aggressive plans. This finding is consistent with the tax uncertainty from aggressive tax avoidance dampening investment. We appreciate the excellent research assistance by Kelly Wentland.

1. Introduction This paper examines how the tax uncertainty created by highly aggressive tax planning can affect a firm s investment decisions. Tax uncertainty can arise from two sources. 1 One source is the inherent incompleteness of the law and its endless legislative, judicial, and administrative modifications. 2 Another source of tax uncertainty, which we study in this paper, arises from intentional tax avoidance that exploits unclear or ambiguous law. For example, a firm might structure complicated supply chains among affiliated companies to mask income shifting across countries. If audited, the firm may be forced to pay additional taxes. However, recognizing that governments have difficulty detecting avoidance and coordinating their efforts, firms accept uncertainty about the eventual taxes levied on these types of investments (if audited) in order to enjoy immediately lower taxes. The more aggressive the tax planning, the greater the tax uncertainty and the more difficult it is to forecast the after-tax returns of an investment. Building on this proposition, we develop a simple model that shows that risk-averse taxpayers will curtail their investments as firm-specific tax uncertainty increases. We test this hypothesis by regressing new investments on known determinants of investments and a measure of the firm-level tax uncertainty that arises from aggressive tax planning. To measure firm-level tax uncertainty, we collect accounting information that is mandated by FASB Interpretation No. 48: Accounting for Uncertainty in Income Taxes (FIN 48). Specifically, we use the firm s current year additions to its 1 This paper uses Niemann s (2011, p.2) definition of tax uncertainty: the deviation of the actual tax payment attributable to an investment project and the tax payment that was anticipated prior to the investment decision. 2 For example, the cost of long-lived assets, such as plant, property and equipment, may be recovered under substantially different tax regimes than those in place when the investment was made, or the current law may not address the tax treatment of innovations.

unrecognized tax benefits from uncertain tax positions (hereafter, FIN 48 additions) to measure tax uncertainty. To our knowledge, this is the first paper to use FIN 48 additions to capture tax uncertainty. Since 2007, FIN 48 has required U.S. firms to report the stock and flow of their unrecognized tax benefits from uncertain tax positions. Simply put, a tax position is how a firm reports an item of income, deduction, or credit on its tax return. Some positions rely on such unclear and ambiguous tax law that they are deemed uncertain. If the company believes that the taxing authorities would prevail if they challenged a tax position, then the tax savings from that position cannot be included in book income (i.e., reduce income tax expense), even though those tax savings reduced the company s actual tax payments. The beginning balance, additions, deletions, and ending balance of these unrecognized tax benefits must be disclosed in the tax footnotes of the financial statements. Since (by definition) FIN 48 additions relate to transactions that reduce current tax payments, we expect that investments are increasing in FIN 48 additions. However, (by definition), the FIN 48 additions relate to transactions whose tax treatment is uncertain. Thus, firms should undertake activities that trigger FIN 48 additions until the marginal benefit of immediately lower taxes equals the marginal cost arising from the uncertainty about the additional taxes to be paid, if and when the taxing authorities audit the position. Therefore, we predict that investments will be increasing, at a decreasing rate, in FIN 48 additions. To test this hypothesis, we regress capital expenditures and research and development on FIN 48 additions, their square, and control variables for about 9,800 firm-years for 2,738 American companies from 2007 2011. We predict a positive sign on FIN 48 additions, consistent with investments increasing in aggressive tax planning. We predict a negative sign on 2

the square of FIN 48 savings, consistent with tax uncertainty eroding the benefits of aggressive tax planning. As predicted, we find a concave relation between investments and FIN 48 additions. We interpret these findings as evidence that aggressive tax avoidance spurs capital expenditures and research and development, but eventually the uncertainty from high-risk tax plans leads companies to rein in their investments. Based on our most robust estimates (Table 4, column 2(i)), we find that FIN48 additions have an economically significant effect on investment. Evaluated at the mean, the level of FIN48 current additions is associated with higher investment of 1.1% of total assets; this represents nearly 14% of new investment. This implies that the lower tax charge associated with aggressive tax planning has a very large impact on total investment. The size of this effect is offset by the increased risk associated with such tax planning, but this effect is much smaller. Again evaluated at the means, the risk of the FIN48 current addition (as measured by its variance) reduces new investment by just under 0.5 percent. To our knowledge, this is the first paper to empirically document that the tax uncertainty, arising from aggressive tax plans, constrains investment. Scholars have modeled the impact of fiscal tax uncertainty (i.e., inherent incompleteness and changing tax policy) on investments (e.g., Niemann, 2011, Hassett and Metcalf, 1999, and Croce et al., 2012, among others) and companies often bemoan its effect. 3 However, no study has attempted to quantify the cost of tax 3 A few examples include: (1) Xstrata CEO Mick Davis response to a 2010 proposed tax in Australia on miners, "The RSPT has created significant uncertainty for the future of mining investment into Australia and would impair the value of previously approved projects and exploration to the point that continued investment can no longer be justified (Reuters, June 3, 2010); (2) Claims of capital flight from India if policymakers change the taxation of foreign investment from Mauritius, a tax haven through which the bulk of Indian foreign investment is routed (The Economic Times, April 20, 2012). (3) An accusation in the UK by Barclays CEO Bob Diamond that the Treasury was increasing uncertainty by retrospectively closing a tax loophole that had previously been deemed acceptable. (Wall Street Journal, May 29, 2012). (4) Annual handwringing in the U.S. about the scheduled expiration of numerous tax provisions. Per the Joint Committee on Taxation, 41 are scheduled to expire at the end of 2012. (5) Pimco CEO Mohamed El-Erian s assertion that, as a result of lack of political leadership on taxes and spending in 3

uncertainty arising from aggressive tax planning. Similarly, several papers have studied FIN 48 (Blouin et al., 2007, 2010, Frischmann et al., 2008, and Mills et al., 2010, among others), but none has used FIN 48 additions to develop a measure of firm-specific tax uncertainty. A scholarly contribution of this paper is that it identifies a firm-level measure of tax uncertainty, which enables testing of the effect of firm-specific tax uncertainty on investments in fixed assets and research and development. The remainder of the paper is as follows. Section 2 develops a model. Section 3 details the research design. Section 4 presents the findings. Closing remarks follow. 2. A simple model of investment and tax avoidance This section develops a model of investment and tax avoidance. We begin by assuming that a risk-averse firm seeks to maximize the expected value of profit less an adjustment for risk, measured by the variance of profit,, multiplied by a factor representing risk aversion,. That is, the firm aims to maximize =. The firm has two instruments: investment in the capital stock, and in tax avoidance activities. Revenue is generated with a production function of and taxed at rate. Relief for capital costs of is given at rate. To model tax avoidance, suppose that the firm can purchase a number of individual tax avoidance schemes,, each of which generates an expected saving in tax of with variance of. The firm chooses to purchase units of tax avoidance plans of proportion of its capital the U.S., The economy is paying a high uncertainty premium right now. With such uncertainty, people delay as many decisions as possible. (New York Times, June 11, 2011). 4

stock. Hence the total expected tax saving is =, and the total variance is =. There is a convex cost of tax avoidance of /2 which is assumed to be tax deductible. Hence, = 1 1 + 1 /2, and First order conditions are: =. : 1 1 + 1 2 : 1 2 =0 2 =0 The first of these generates an extended form of the normal expression equation the marginal product of capital and the cost of capital: where is the conventional cost of capital, = + 2 1 +2 1 = 1 1 and the subsequent terms reflect tax avoidance activities: the expected benefit, and the costs in terms of purchase of the schemes and greater risk. From the second first-order equation, the optimal amount of tax avoidance is given by = 1 +2. Note that neither of these expressions is closed-form solutions, since appears on both sides of each equation. 5

To develop the empirical research equation, assume a Cobb-Douglas form for the production function, =, then = Using this, we have from the first-order condition for capital: 2 = 1 +2 1 where the dependent variable can be thought of as net revenue (after current costs of tax avoidance) or, which we observe. is the FIN 48 additions, which we observe. is the variance of the FIN 48 additions, which we do not observe but can estimate. Suppose there are two equally probable outcomes of each tax avoidance scheme, zero and 2. This generates an expected value of and a variance of = =. That leads to or = 1 +2 1 1+ 1 2 1 = Taking logs, and using the approximation that 1+ 1 2 1 1 2 1 6

we have = + 1 2 1 The first part of this equation is standard. The main innovation is to add two terms which depend on tax avoidance. The first term is the ratio of expected tax saved to net revenue. It has a positive effect on investment. The second term is the ratio of the expected tax saved squared to revenue, a measure of uncertainty, which has a negative effect on investment. In the empirical tests below, we measure the firm term using the FIN 48 additions. To measure the second term, we square the FIN 48 additions. 3. Research design 3.1.Empirical Model We test for evidence of the role of tax uncertainty by estimating the following empirical specification based on the model developed above: = + + + h + + + + where New Investment equals the sum of capital expenditures, R&D, and cash acquisitions less depreciation and sales of property, plant and equipment scaled by average total assets. Our definition is based on Richardson (2006) s insight that new investment is equal to total investment less some level of investment required for maintenance. 7

For Tax Avoidance we use the firm s current year additions to its unrecognized tax benefits from uncertain tax positions (FIN additions) scaled by average total assets. De Waegenaere, Sansing, and Wielhouwer (2010) provide a theoretical analysis suggesting that the FIN 48 unrecognized tax benefit is the best financial-statement-generated measure of the level of firm tax avoidance. 4 We focus primarily on additions related to the current year (Change in FIN 48 Curr YR), rather than the total change in FIN 48, as this activity represents the avoidance activity directly related to the cash flows from tax planning in the year of the investment decision. As far as we are aware, the FIN 48 measure is the only proxy which specifically allows us to measure the firms incremental tax avoidance activity attributable to a particular period. Because tax planning provides additional cash flow to be used towards investment, we anticipate that β 1 will be positive. In addition, we consider the association between New Investment and the other components of the change in the FIN 48 (i.e., the change in FIN 48 associated with prior years activity (Change in FIN 48 Prior YR); the change associated with tax authority settlement activity (Settlement Ch. In FIN 48); and the change in FIN 48 associated with the lapse in the statute of limitations (Statute Ch. in FIN 48). We include Tax Avoidance 2 to capture the uncertainty inherent in tax avoidance activities and predict that β 2 will be negative. Sales Growth is included to capture changes in demand that would require additional investment (Bond et al. 2007). We anticipate that β 3 will be positive. As additional controls, we include several variables that we surmise are correlated with incremental investment. First, we include the debt to equity ratio because firms with high debt leverage are likely to be more liquidity constrained and therefore have less discretionary funds to 4 Their assertion is contingent on the quality of firms compliance with the FIN 48 reporting regime. For example, FIN 48 is less useful as a measure of tax aggressiveness if firms use the FIN 48 accrual to manage earnings, as suggested by Hanlon and Heitzman (2010). 8

finance incremental investment. Second, return on assets is included as a proxy for firm profitability. The association between investment and return on assets is ambiguous. Although more profitable firms likely fund more investment, return on assets may be negatively associated with New Investment because higher incremental investment increases total assets and decreases net income via depreciation. Third, we include the natural logarithm of a firm s market value of equity as a measure of firm size. We have no prediction on the association between size and investment. 3.2.Sample selection and data We begin our sample selection be identifying publically traded U.S. incorporated firms from among all firms in Compustat between 2007 and 2011 (excluding REITS, banks, and insurers). To prevent our analysis from being unduly influenced by small firms, we eliminate observations where stock price is less than $1 or where average assets are less than $10 million. The sample begins in 2007, the first year that FIN 48 data are available. We supplement the FIN 48 data in Compustat with Capital IQ data. 5 New Investment, Sales Growth (e.g., change in sales from t-1 to t), Debt to Equity, Return on Assets and Size are all estimated using Compustat data. All continuous variables are winsorized at the top and bottom 0.5%. These criteria result in a sample of 9,848 firm-year observations representing 2,748 unique firms. 4. Results 4.1.Descriptive statistics Table 1 presents descriptive statistics on the sample. Mean (median) New Investment is 8% (3.7%) of average assets. The key tax avoidance measure, Change in FIN 48 Curr YR, is the largest component of FIN 48 activity at 0.16% of average total assets. With a mean total 5 2007 and 2008 FIN 48 data often appear missing in Compustat, e.g., see International Business Machines. 9

assets of $4.84 billion in the sample, the average change in the FIN 48 associated with current year tax positions is roughly $8 million. 4.2. Multivariate Analysis Table 2 reports summary statistics from estimating the regression model using ordinary least squares. As predicted, both specifications in Panel A show the coefficients on Change in FIN 48 Curr YR are positive and the coefficients on Change in FIN 48 Curr YR 2 are negative. These results are consistent with New Investment increasing in the level of tax avoidance, suggesting tax planning is a source of financing. More importantly for this paper, the negative coefficient on Change in FIN 48 Curr YR 2 is consistent with higher levels of tax avoidance yielding more uncertainty about whether the firm will retain the proceeds from tax planning. Among the control variables, the coefficient on Sales Growth is positive and significant, implying that investment increases with demand for the firm s goods and services. The Debt to Equity coefficient is negative and significant, consistent with heavily leveraged firms spending less on incremental investment. The coefficient on Return on Assets is significantly negative, implying that higher levels of investment either increase (decrease) the denominator (numerator) of this ratio. Finally, size does not appear to be a significant determinant of investment. Next, we add other FIN 48 disclosures to the regression model to determine whether they alter the inferences drawn above. Table 2, Panel B reports the results. Columns (3) and (4) add Change in FIN 48 Prior YR and Change in FIN 48 Prior YR 2 to the original model. To that modified model, Columns (5) and (6) add Settlement Ch. in FIN 48 and Settlement Ch. in FIN 48 2. Finally, Columns (7) and (8) include Statute Ch. in FIN 48 and Statute Ch. in FIN 48 2. We find that the coefficients on Change in FIN 48 Curr YR and Change in FIN 48 Curr YR 2 remain significantly positive and negative, respectively, for every specification. Furthermore, 10

the signs on all control variables are consistent with the specifications in Table 2 Panel A. We infer from these results that investment increases, at a decreasing rate, in FIN 48 additions, even after considering other FIN 48 disclosures. Next, we aggregate each of our flow variables over three years to test whether results hold over a longer period. Table 3 shows that the coefficients on Change in FIN 48 Curr YR remain significant and positive. The coefficients on Change in FIN 48 Curr YR 2 remain negative, but only significant when we include the entire set of control variables. We infer that the concavity between investment and aggressive tax planning (as measured by FIN 48 additions) mostly holds over a three-year period. 4.3. Potential Endogeneity A potential problem with our analyses is that the explanatory variables are endogenous. For example, contemporaneous sales growth may lead to incremental investment or incremental investment may lead to sales growth. In addition, the theoretical model implies that investment and tax planning decisions are taken jointly; this may imply that the FIN 48 variables are also endogenous. To test the possibility of endogeneity, we undertake additional tests and report the results in Table 4. The first column of Table 4 reprints the baseline OLS results from Table 2, Panel A. In Table 4 Column (1)(i), we report the results of two-stage least squares where we instrument Sales Growth with two lags of sales growth (i.e., the change in sales between t-2 and t-1 and the change in sales between t-2 and t-3). We fail to reject the null of the test of over-identification using Sargan's (1958) and Basmann's (1960) chi-squared tests, suggesting that the instruments are valid. Consistent with endogeneity biasing our coefficient on Sales Growth, the coefficient on Sales Growth increases ten-fold between Columns (1) and (1)(i). The coefficients on both 11

Change in FIN 48 Curr YR and Change in FIN 48 Curr YR 2 continue to have the predicted sign, although only Change in FIN 48 Curr YR remains statistically significant. Columns (2) and (2)(i) repeat the tests from Columns (1) and (1)(i), including the additional control variables. Once again, the coefficient on Sales Growth increases precipitously with two-stage least squares. The coefficients on Change in FIN 48 Curr YR and Change in FIN 48 Curr YR 2 are significant in the predicted direction. We again fail to reject the null of the test of overidentifying restrictions. Since all of the variables treated as exogenous are automatically used as instruments in the IV procedure, this suggests that there is no problem of endogeneity either for the FIN 48 variables, or the additional control variables. Given that the additional control variables are significant, Column 2(i) is therefore our preferred specification. Nevertheless, as an additional robustness check, we also instrument the Fin 48 variables. Columns (1)(ii) and (2)(ii) report results when we instrument Change in FIN 48 Curr YR and Change in FIN 48 Curr YR 2 with the log of the number of tax havens and the squared log of the number of tax havens listed in firms Exhibit 21 of their 10-Ks (see Dyreng and Lindsey, 2009). Unfortunately, requiring the Exhibit 21 data substantially reduces the sample size In this case, we again fail to reject the null of the test of over-identifying restrictions. However, either because of the reduction in sample size, or because of instrumenting, the precision of our estimates is greately reduced, and we are not able to identify any of the coefficients in column 1(ii) as being signficantly different from zero. 6 In Column 2(ii) we follow the same procedure 6 Note that our results are similar if we instrument the Change in FIN 48 Curr YR with the number of countries found in firms Exhibit 21, the number of affiliates reported in firms Exhibit 21, and the percentage of affiliates in tax havens reported in Exhibit 21, If we use the firms difference between their domestic effective tax rate and their foreign effective tax rate, we find that the coefficients on Change in FIN 48 Curr YR and Change in FIN 48 Curr YR 2 are in the predicted direction. Finally, when we use the Hirfidahl measure of business complexity developed in Bushman, Chen, Engel and Smith (2004) we find that the coefficients on Change in FIN 48 Curr YR and Change in FIN 48 Curr YR 2 are in the predicted direction but only Change in FIN 48 Curr YR is statistically significant. 12

while including the other control variables. The debt-equity ratio and the return on assets variables are significant in this specification, as is sales growth. However, the Fin 48 variables remain insignificant. 4.4 Permanent versus temporary change in FIN 48 The final tests investigate whether the permanent or temporary portion of FIN 48 currentyear additions drives the association between tax avoidance and investment. Timing book-tax differences eventually reverse. Since the income or deduction will eventually be reflected in both taxable income and book income, timing differences have no impact on firms book effective tax rates and thus no effect on accounting earnings. In contrast, permanent book-tax differences are reflected in book income but are never reported in taxable income or vice versa, e.g., fines and municipal bond income. Because of the permanence of these items, they affect book effective tax rates and therefore book income. Other rate reconciling items, such as foreign and state tax rate differentials and tax credits, also affect book effective tax rates. Although they are not differences in book and taxable income, we follow custom and treat them as permanent book-tax differences. 7 Since permanent book-tax differences affect both cash flow and book earnings but temporary differences only affect cash, we expect that firms are more concerned about uncertainty arising from permanent book-tax differences than uncertainty from temporary booktax differences. To investigate our conjecture, we partition the Change in FIN 48 Curr YR into its permanent and temporary components. Although FIN 48 requires firms to report the portion of the FIN 48 balance attributable to permanent differences (i.e., firms must report the portion that would affect the effective tax rate if reversed), FIN 48 does not require firms to partition this 7 For further details, see Hanlon and Heitzman (2010) and Graham, Raedy and Shackelford (2012). 13

amounts by current year, prior year, settlement and/or statute lapse activity. Therefore, we must estimate the portion of the change in FIN 48 attributable to current year tax positions that is permanent and temporary. We take two approaches to our estimation. First, we estimate the current change in the permanent FIN 48 component associated with current year tax positions (Permanent Ch. in FIN 48) as the change in the FIN 48 balance associated with current year tax positions times the ratio of the change in the permanent component of change in the FIN 48 reserve to the total change in the FIN 48 reserve. The timing component attributable to current year activity (Timing Ch. in FIN 48) is the Change in FIN 48 Curr YR less Permanent Ch. in FIN 48. Unfortunately, because we need the change in the permanent component for this computation, we lose all 2007 observations. Therefore, to preserve the sample, we undertake a second estimation approach. We estimate the current change in the permanent FIN 48 component associated with current year tax positions using the difference between the effective tax rate at the top U.S. statutory tax rate (35%) to estimate firms aggregate permanent book-tax differences (difference between the statutory tax rate and the effective tax rate times pre-tax book income grossed up by the statutory tax rate). We then estimate the portion of firms book-tax differences that are permanent by dividing the estimated aggregate permanent book-tax differences by total book-tax differences (pre-tax book income less estimated taxable income, i.e., current federal tax expense grossed up by the statutory tax rate). We then multiply this ratio times Change in FIN 48 Curr YR to estimate the portion of current year activity that is permanent in nature, Permanent BTD Ch. in FIN 48. As above, the timing activity is then estimated to be Change in FIN 48 Curr YR minus Permanent BTD Ch. in FIN 48. 14

Table 5 reports the results of partitioning our tax avoidance variable into its permanent and timing components. Consistent with our expectations that permanent tax avoidance activity creates more uncertainty, we find that both Permanent Ch. in FIN 48 2 and Permanent BTD Ch. in FIN 48 2 are significantly negative when included with Change in FIN 48 Curr YR 2 (see columns 9, 10, 13 and 14). Furthermore, when we include Permanent Ch. in FIN 48 2 and Permanent BTD Ch. in FIN 48 2 along with Timing Ch. in FIN 48 2 and timing BTD Ch. in FIN 48 2 we find that it is the permanent component of the current year s activity that is driving our inferences (see columns 11, 12, 15 and 16). Conclusion This paper investigates the impact of aggressive tax avoidance on company investment. We present a model in which companies simultaneously choose their tax avoidance strategy and their investment. Aggressive tax avoidance reduces the tax liability on the returns earned on investment and so is associated with greater investment. However, greater aggression is also associated with greater risk that the tax planning is not accepted by the tax authorities or the courts. We expect tax planning to increase up to the point at which this greater uncertainty offsets at the margin the benefits of expected lower taxes. This additional uncertainty discourages investment. We test the theory using evidence from US corporations. Significantly, US corporations are required to account for uncertainty in income taxes, as set out by FASB Interpretation no. 48. We include the current addition to the FIN 48 charge as a measure of the uncertain tax benefit in each year, and we include the variance of this change to allow for additional uncertainty to have 15

an increasingly negative effect on investment. We use data for 2,748 companies in Compustat between 2007 and 2011 (excluding REITS, banks, and insurers). We add hand-collected information on the FIN 48 addition, and end up with a sample of 9,848 firm-year observations. The empirical results support the hypotheses developed. A higher current FIN 48 addition reflecting higher, though uncertain, tax saving from tax planning - is associated with considerably higher investment: new investment would be nearly 14% lower in the absence of the FIN 48 addition. This effect diminishes as the FIN 48 addition rises, reflecting additional uncertainty. 16

References Bloom, N., Bond, S., Van Reenen, J., 2007. Uncertainty and Investment Dynamics, Review of Economic Studies 74: 391-415. Blouin, J., Gleason, C., Mills, L., Sikes, S., 2007. What can we learn about uncertain tax benefits from FIN 48? National Tax Journal 60(3), 521-535. Blouin, J., Gleason, C., Mills, L., Sikes, S., 2010. Pre-empting disclosure? Firms decisions prior to FIN 48, The Accounting Review 85(3), 791-815. Bushman, R., Chen, Q., Engel, E., Smith, A., 2004. Financial accounting information, organizational complexity and corporate governance systems. Journal of Accounting & Economics 37, 167-201. Croce, M., Kung, H, Nguyen, T., Schmid, L., 2012. Fiscal Policies and Asset Prices, University of North Carolina working paper. De Waegenaere, A., Sansing, R., Wielhouwer, J. 2010. Financial accounting measures of tax reporting aggressiveness. Tilburg University working paper. Dyreng, S., Lindsay, B., 2009. Using Financial Accounting Data to Examine the Effect of Foreign Operations Located in Tax Havens and Other Countries on US Multinational Firms Tax Rates. Journal of Accounting Research 47 (5), 1283-1316. Frischmann, P., Shevlin, T., Wilson, R., 2008. Economic consequences of increasing the conformity in accounting for uncertain tax benefits, Journal of Accounting and Economics 46, 261-278. Graham, J., Raedy, J., Shackelford, D., 2012. Research in Accounting for Income Taxes, Journal of Accounting and Economics. Hanlon, M., and Heitzman, S., 2010. Tax Research: Real Effects, Reporting Effects, and Governance. Journal of Accounting and Economics 50, 127-184. Hassett, K., and Metcalf, G., 1999. Investment with Uncertain Tax Policy: Does Random Tax Policy Discourage Investment? The Economic Journal 109: 372-393. Mills, L., Robinson, L., Sansing, R., 2010. FIN 48 and Tax Compliance. The Accounting Review, 86(5), 1721-1742. Niemann, R., 2011. The Impact of Tax Uncertainty on Irreversible Investment, Review of Management Science 5:1-17. 17

Richardson, S., 2006. The Over-Investment of Free-Cash Flow, Review of Accounting Studies 11: 159-189. 18

Appendix Summary of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes This paper uses disclosures mandated by Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes, to construct its measures of tax uncertainty. Enacted in 2006, the FASB s stated intention was to enhance the relevance and comparability of the financial reporting of income taxes by providing increased standardization to the process by which firms recognize and measure the tax benefits arising from uncertain tax positions. Effective for all U.S. GAAP financial reporting enterprises for tax years beginning after December 15, 2006, FIN 48 applies to all income tax positions. FIN 48 states that a firm can only recognize the tax benefits from a tax position if it is more likely than not (i.e., the probability exceeds 50%) that the firm s tax position (based on its technical merits) will be sustained upon examination by a taxing authority. The company must assume that the taxing authorities will examine every tax position and that they will have access to all documentation, knowledge and support about the position. To the extent the "more likely than not" standard is not met, then a company cannot recognize the tax benefits from that tax position. FIN 48 requires that firms provide in their financial reports details about it uncertain tax positions and a reconciliation of these unrecognized tax benefits. The following disclosures are from the tax footnote of Walmart s 2012 annual report. 19

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Table 1 Descriptive Statistics N Mean Median Standard deviation Q1 Q3 Dependent variables New Investment 9,848 0.0803 0.0366 0.1379 0.0007 0.1176 New Investment 3 year 9,848 0.2291 0.1513 0.3217 0.0285 0.3435 Tax variables Change in FIN 48 Curr YR 9,848 0.0016 0.0004 0.0034 0 0.0017 Change in FIN 48 Prior YR 9,845 0.0001 0 0.0034 0.0001 0.0004 Settlement Ch. in FIN 48 9,843 0.0007 0 0.0025 0 0.0003 Statute Ch. in FIN 48 9,843 0.0006 0 0.0017 0 0.0004 Change in FIN 48 Curr YR- 3 year 9,843 0.0038 0.0011 0.0076 0 0.0042 Permanent Ch. in FIN 48 6,442 0.0013 0.0001 0.0094 0 0.0012 Timing Ch. in FIN 48 6,442 0.0006 0 0.0092 0 0.0006 Permanent BTD Ch. in FIN 48 9,848 0.0011 0 0.0074 0 0.0006 Timing BTD Ch. in FIN 48 9,848 0.0005 0.0000 0.0059 0 0.0008 Instrumental variable for tax variables and sales growth Log # of Tax Havens 3,798 0.9551 0.6931 0.7794 0 1.6094 Financial variables Sales Growth 9,848 0.1442 0.0666 0.6592 0.0454 0.1905 Debt to Equity 9,791 0.5513 0.1536 1.3640 0.0043 0.4984 Return on Assets 9,847 0.0124 0.0417 0.2035 0.0191 0.0894 Size 9,841 6.5221 6.4644 1.9063 5.2349 7.7398 Sales Growth 3 year 9,366 0.6728 0.1627 3.8743 0.0693 0.5098 Return on Assets 3 year 9,429 0.0061 0.1397 0.6515 0.0768 0.2912 Return on Assets 3 year 9,429 0.0061 0.1397 0.6515 0.0768 0.2912 22

Table 1 - Continued Variable name New Investment New Investment 3 year Change in FIN 48 Curr YR Change in FIN 48 Prior YR Settlement Ch. in FIN 48 Statute Ch. in FIN 48 Change in FIN 48 Curr YR- 3 year Permanent Ch. in FIN 48 Timing Ch. in FIN 48 Permanent BTD Ch. in FIN 48 Timing BTD Ch. in FIN 48 Definition is defined as in Richardson (2007) and equals (capital expenditures sales + R&D + cash acquisitions depreciation) / average total assets over a one year period. is defined the same as New Investment except that it is taken over a three year period. is the current year change in FIN 48 balance attributable to changes in tax positions taken in the current year scaled by average total assets. is the current year change in FIN 48 balance attributable to changes in tax positions taken in prior years scaled by average total assets. is the portion of Change in FIN 48 attributable to settlements with tax authorities. Note that a positive number implies a decrease in the FIN 48 balance. is the portion of Change in FIN 48 Curr YR attributable to lapses in the statute of limitations. Note that a positive number implies a decrease in the FIN 48 balance. is defined the same as Change in FIN 48 Curr YR except that it is taken over a three year period. equals the current change in the permanent FIN 48 component where the change in the permanent component is estimated based on Change in FIN 48 Curr YR times the ratio of the change in the permanent component of change in the FIN 48 reserve to the total change in the FIN 48 reserve. equals the current change in the timing FIN 48 component estimated as total current change in the FIN 48 reserve - Permanent Ch. in FIN 48. equals the current change in the permanent FIN 48 component where the change in the permanent component is estimated based on the ratio of permanent book-tax differences (difference between the statutory tax rate and the ETR times pre-tax book income grossed up by the statutory tax rate) as a function of total book-tax differences (pre-tax book income less estimated taxable income {current federal tax expense grossed up by the statutory tax rate}). equals the current change in timing FIN 48 component estimated as total current change in the FIN 48 reserve - Permanent BTD Ch. in FIN 48. Log # of Tax Havens Sales Growth Debt to Equity Return on Assets Size Sales Growth 3 year Return on Assets 3 year is the number of tax havens, which is defined as the number of material operations a firm has listed in certain low tax countries in exhibit 21 of form its 10-K (similar to Dyreng and Lindsay (2009)). is the current year change in sales scaled by average total assets. equals total debt / total equity. equals net income / lagged assets. is defined as the log of the market value of equity. is defined the same as Sales Growth except that it is taken over a three year period. is defined the same as Return on Assets except that it is taken over a three year period. 23

Table 2 Panel A Influence of tax planning on new investment (using new investment over a one year period) New Investment Prediction (1) (2) Change in FIN 48- Curr YR + 6.562*** 7.656*** (3.76) (4.43) (Change in FIN 48 Curr YR) 2 168.388** 217.873*** ( 2.22) ( 2.83) Sales Growth 0.036*** 0.034*** (7.52) (6.60) Debt to Equity 0.010*** ( 3.90) Return on Assets 0.167*** ( 12.72) Size 0.001 ( 0.96) Intercept 0.045*** 0.061*** (6.73) (5.92) N Observations 9,848 9,790 Adjusted R squared 0.220 0.281 Year fixed effects Yes Yes Industry fixed effects Yes Yes This table presents the estimates of Eq. (1) and (2) where the dependent variable used in both equations is firm New Investment. New Investment is defined as in Richardson (2007) and equals (capital expenditures sales + R&D + cash acquisitions depreciation) / average total assets over a one year period. Change in FIN 48 Curr YR is the current year change in FIN 48 balance attributable to changes in tax positions taken in the current year scaled by average total assets. This variable squared equals (Change in FIN 48 Curr YR) 2. Sales Growth is the current year change in sales. Debt to Equity equals total debt / total equity. Return on Assets equals net income / lagged assets. Size is defined as the log of the market value of equity. All continuous variables have been winsorized at the top and bottom 0.5%. t statistics calculated using robust standard errors are reported in parentheses below the coefficient estimates. *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels, respectively. 24

Table 2 - continued Panel B Influence of tax planning components on new investment (using new investment over a one year period) New Investment (3) (4) (5) (6) (7) (8) Change in FIN 48 Curr YR 6.275*** 7.419*** 7.135*** 7.902*** 7.771*** 8.376*** (3.67) (4.36) (4.23) (4.70) (4.30) (4.67) (Change in FIN 48 Curr YR) 2 162.555** 212.945*** 194.832*** 230.927*** 219.417*** 248.913*** ( 2.15) ( 2.77) ( 2.60) ( 3.02) ( 2.74) ( 3.07) Change in FIN 48 Prior YR 0.948** 0.917** 0.921** 0.907*** 0.948** 0.938*** (2.06) (2.41) (2.22) (2.67) (2.23) (2.70) (Change in FIN 48 Prior YR) 2 113.082*** 90.293*** 124.007*** 99.169*** 124.403*** 99.852*** (3.01) (2.74) (3.47) (3.12) (3.39) (3.04) Settlement Ch. in FIN 48 7.722*** 6.207*** 7.349*** 5.972*** ( 4.70) ( 3.91) ( 4.45) ( 3.71) (Settlement Ch. in FIN 48) 2 268.306*** 216.880** 257.816*** 211.126** (3.01) (2.42) (2.86) (2.33) Statute Ch. in FIN 48 9.603*** 7.296*** ( 7.15) ( 6.23) (Statute Ch. in FIN 48) 2 761.134*** 546.681*** (5.46) (4.08) Sales Growth 0.036*** 0.033*** 0.035*** 0.033*** 0.034*** 0.032*** (7.47) (6.53) (7.41) (6.50) (7.21) (6.32) Debt to Equity 0.010*** 0.009*** 0.009*** ( 3.84) ( 3.75) ( 3.77) Return on Assets 0.166*** 0.166*** 0.165*** ( 13.02) ( 12.85) ( 12.72) Size 0.001 0.000 0.000 ( 0.91) (0.08) (0.22) Intercept 0.045*** 0.060*** 0.048*** 0.057*** 0.051*** 0.059*** (6.58) (5.90) (7.24) (5.77) (7.25) (5.85) N Observations 9,845 9,787 9,843 9,785 9,841 9,783 Adjusted R squared 0.223 0.283 0.227 0.286 0.230 0.287 Year fixed effects Yes Yes Yes Yes Yes Yes Industry fixed effects Yes Yes Yes Yes Yes Yes 25

This table presents the estimates of Eq. (3) - (8) where the dependent variable used in all equations is firm New Investment. New Investment, Change in FIN 48 Curr YR, (Change in FIN 48 Curr YR) 2, Sales Growth, Debt to Equity, Return on Assets, and Size are defined in the same way as in Table 2 Panel A. Change in FIN 48 Prior YR is the current year change in FIN 48 balance attributable to changes in tax positions taken in prior years scaled by average total assets Settlement Ch. in FIN 48 is the portion of Change in FIN 48 attributable to settlements with tax authorities. This variable squared is (Settlement Ch. in FIN 48) 2. Settlement Ch. in FIN 48 is the portion of Change in FIN 48 Curr YR attributable to lapses in the statute of limitations. This variable squared is (Statute Ch. in FIN 48) 2. All continuous variables have been winsorized at the top and bottom 0.5%. t statistics calculated using robust standard errors are reported in parentheses below the coefficient estimates. *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels, respectively. 26

Table 3 Influence of tax planning on new investment (using new investment over a three year period) New Investment 3 year Prediction (1) (2) Change in FIN 48 Curr YR - 3 year + 4.892*** 6.119*** (3.62) (4.96) (Change in FIN 48 Curr YR - 3 year) 2 14.347 56.444** ( 0.52) ( 2.47) Sales Growth 3 year 0.006** 0.003* (2.11) (1.84) Debt to Equity 0.019* ( 1.66) Return on Asset 3 year 0.159*** ( 7.45) Size 0.002 (0.89) Intercept 0.073*** 0.075*** (3.72) (3.15) N Observations 9,529 9,465 Adjusted R squared 0.271 0.369 Year fixed effects Yes Yes Industry fixed effects Yes Yes This table presents the estimates of Eq. (1) and (2) where the dependent variable used in both equations is firm New Investment 3 year. New Investment 3 year, Change in FIN 48 Curr YR - 3 year, Sales Growth 3 year, and Return on Assets 3 year are defined in the same way as in Table 2 Panel A except that these variables are taken over a three year period instead of a one year period. Change in FIN 48 Curr YR - 3 year is squared to define the variable (Change in FIN 48 Curr YR - 3 year) 2. Debt to Equity and Size are defined as in Table 2 and retain calculation over a one year period. All continuous variables have been winsorized at the top and bottom 0.5%. t statistics calculated using robust standard errors are reported in parentheses below the coefficient estimates. *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels, respectively. 27

Table 4 Comparison of OLS and Instrumental Variables for potential endogeneity in Change in FIN 48 Curr YR, (Change in FIN 48 Curr YR) 2, and Sales Growth (using new investment over a one year period) New Investment OLS (1) IV for Sales Growth (1)(i) IV for Change in FIN 48 Curr YR, (Change in FIN 48 Curr YR) 2, Sales Growth (1)(ii) OLS (2) IV for Sales Growth (2)(i) IV for Change in FIN 48 Curr YR, (Change in FIN 48 Curr YR) 2, Sales Growth (2)(ii) 6.932 Change in FIN 48 Curr YR 6.562*** 5.132*** 81.993 7.656*** 6.860*** ( 1.13) (3.76) (3.50) ( 1.01) (4.43) (5.02) 0.000 (Change in FIN 48 Curr YR) 2 168.388** 65.423 7,678.505 217.873*** 143.462* (0.00) ( 2.22) ( 0.78) (0.92) ( 2.83) (-1.90) 0.140*** Sales Growth 0.036*** 0.333** 0.119 0.034*** 0.279** (2.67) (7.52) (2.15) (1.28) (6.60) (2.14) 0.007*** Debt to Equity 0.010*** 0.009*** ( 3.96) (-3.90) ( 4.48) 0.086*** Return on Assets 0.167*** 0.150*** ( 2.73) ( 12.72) ( 4.14) 0.002 Size 0.001 0.002 (0.72) ( 0.96) ( 1.26) 0.056*** Intercept 0.045*** 0.033*** 0.118* 0.061*** 0.059*** (3.65) (6.73) (2.92) (1.80) (5.92) (5.15) OverID χ 2 pvalue N/A 0.6169 0.7598 N/A 0.7776 3,576 N Observations 9,848 9,029 3,599 9,790 8,975 0.045 Adjusted R squared 0.220 N/A N/A 0.281 N/A 6.932 Year fixed effects Yes Yes Yes Yes Yes Yes Industry fixed effects Yes Yes Yes Yes Yes Yes 0.1869 28

This table presents the OLS estimates of Eq. (1) and (2) with relevant 2SLS estimates of Eq. (1)(i) and (ii) and (2)(i) and (ii). The dependent variable in all six estimates (columns) is firm New Investment. New Investment is defined as in Richardson (2007) and equals (capital expenditures sales + R&D + cash acquisitions depreciation) / average total assets over a one year period. Change in FIN 48 Curr YR is the current year change in FIN 48 balance attributable to changes in tax positions taken in the current year scaled by average total assets. This variable squared equals (Change in FIN 48 Curr YR) 2. Sales Growth is the current year change in sales. Debt to Equity equals total debt / total equity. Return on Assets equals net income / lagged assets. Size is defined as the log of the market value of equity. All continuous variables have been winsorized at the top and bottom 0.5%. Equations (1)(i) and (2)(i) use the following set of instruments to address potential endogeneity in Change in FIN 48 Curr YR, (Change in FIN 48 Curr YR) 2, and Sales Growth: Log # of Tax Havens, (Log # of Tax Havens) 2, and the second and third period lags of Sales Growth. Log # of Tax Havens is the number of tax havens, which is defined as the number of material operations a firm has listed in certain low tax countries in exhibit 21 of form its 10-K (similar to Dyreng and Lindsay (2009)). The only difference in Equations (1)(i) and (2)(i) is that Equation (2)(i) includes the additional controls Debt to Equity, Return on Assets, and Size. Equations (1)(ii) and (2)(ii) use the second and third period lags of Sales Growth as instruments to address potential endogeneity in Sales Growth. The only difference in Equations (1)(ii) and (2)(ii) is that Equation (2)(ii) includes the additional controls Debt to Equity, Return on Assets, and Size. t statistics calculated using robust standard errors are reported in parentheses below the coefficient estimates. *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels, respectively. 29

Table 5 Influence of permanent and timing tax planning components on new investment (using new investment over a one year period) New Investment (9) (10) (11) (12) (13) (14) (15) (16) Change in FIN 48 Curr YR 10.015*** 10.433*** 6.234*** 7.503*** (6.99) (7.34) (3.53) (4.30) (Change in FIN 48 Curr YR) 2 320.543*** 347.768*** 152.540* 210.326** ( 5.77) ( 6.40) ( 1.83) ( 2.46) Permanent Ch. in FIN 48 0.079 0.202*** 2.541*** 2.471*** (1.31) (4.10) (2.90) (3.20) (Permanent Ch. in FIN 48) 2 4.179** 4.642*** 14.094*** 12.945*** ( 2.52) ( 4.11) ( 4.02) ( 16.64) Timing Ch. in FIN 48 2.241** 2.089** (2.28) (2.33) (Timing Ch. in FIN 48) 2 11.396*** 9.710*** (2.80) (5.62) Permanent BTD Ch. in FIN 48 0.615*** 0.264*** 3.187*** 2.973*** (6.66) (3.62) (4.46) (4.61) (Permanent BTD Ch. in FIN 48) 2 10.093*** 4.426 21.594*** 20.284*** ( 2.83) ( 1.23) ( 3.21) ( 3.62) Timing BTD Ch. in FIN 48 2.550*** 2.565*** (3.35) (3.54) (Timing BTD Ch. in FIN 48) 2 11.774* 17.820*** (1.92) (4.95) Sales Growth 0.045*** 0.041*** 0.046*** 0.042*** 0.036*** 0.034*** 0.036*** 0.033*** (10.15) (6.89) (10.09) (7.05) (7.48) (6.59) (7.44) (6.55) Debt to Equity 0.009*** 0.009*** 0.010*** 0.010*** ( 4.18) ( 4.17) ( 3.90) ( 3.87) Return on Assets 0.126*** 0.127*** 0.167*** 0.166*** ( 8.61) ( 7.99) ( 12.59) ( 12.39) Size 0.003*** 0.002 0.001 0.000 ( 3.24) ( 1.50) ( 0.95) (0.33) Intercept 0.033*** 0.034*** 0.039*** 0.030** 0.046*** 0.061*** 0.048*** 0.057*** (4.24) (2.81) (4.76) (2.41) (6.74) (5.95) (7.10) (5.92) N Observations 6,442 6,403 6,442 6,403 9,848 9,790 9,848 9,790 Adjusted R squared 0.225 0.262 0.212 0.247 0.221 0.281 0.218 0.277 Year fixed effects Yes Yes Yes Yes Yes Yes Yes Yes Industry fixed effects Yes Yes Yes Yes Yes Yes Yes Yes 30

This table presents estimates of Eq. (9) (16). New Investment, Change in FIN 48 Curr YR, (Change in FIN 48 Curr YR) 2, Sales Growth, Debt to Equity, Return on Assets, and Size are defined in the same way as in Table 2 Panel A. The remaining variables relate to permanent and timing components of Change in FIN 48 Curr YR. But, there are two methods used to determine these components, one using ratios of the components of FIN 48 reserve change to the total FIN 48 reserve change and the other using ratios of component book-tax differences to total book-tax differences. Permanent Ch. in FIN 48 equals the current change in the permanent FIN 48 component where the change in the permanent component is estimated based on the ratio of the change in the permanent component of change in the FIN 48 reserve to the total change in the Fin 48 reserve. Timing Ch. in FIN 48 equals the current change in the timing FIN 48 component estimated as total current change in the FIN 48 reserve - Permanent Ch. in FIN 48. Permanent BTD Ch. in FIN 48 equals the current change in the permanent FIN 48 component where the change in the permanent component is estimated based on the ratio of permanent book-tax differences (difference between the statutory tax rate and the ETR times pre-tax book income grossed up by the statutory tax rate) as a function of total book-tax differences (pre-tax book income less estimated taxable income {current federal tax expense grossed up by the statutory tax rate}). Timing BTD Ch. in FIN 48 equals the current change in timing FIN 48 component estimated as total current change in the FIN 48 reserve - Permanent BTD Ch. in FIN 48. (Permanent Ch. in FIN 48) 2, (Timing Ch. in FIN 48) 2, (Permanent BTD Ch. in FIN 48) 2, and (Timing BTD Ch. in FIN 48) 2 are variables calculated as the square of the relevant permanent or temporary component estimates described above. All continuous variables have been winsorized at the top and bottom 0.5%. t statistics calculated using robust standard errors are reported in parentheses below the coefficient estimates. *, **, and *** denote statistical significance at the 10%, 5%, and 1% levels, respectively. 31