The Accounting Review Vol. 87, No. 5 September 2012: Do IRS Audits Deter Corporate Tax Avoidance? pot

  The American Accounting Association is the largest community of accountants in academia Founded in 1916, we have a rich and reputable history built on leading-edge research and publications The diversity of our membership creates a fertile environment for collaboration and innovation Collectively, we shape the future of accounting through teaching, research and a powerful network, ensuring our position as thought leaders in accounting The Accounting Review Vol 87, No September 2012 Do IRS Audits Deter Corporate Tax Avoidance? American Accounting Association | Publications The American Accounting Association is the copyright holder of this article and retains the worldwide rights to publish, reproduce, distribute, publicly display and/or license the Material in this article for any future editions and versions of this Work, derivative works based on this article (including translations and adaptations), related ancillaries and supplements, and in promotional materials in all print, digital and wireless and/or electronic formats Further distribution of this article is strictly prohibited Written application must be made to the American Accounting Association, 5717 Bessie Drive, Sarasota, Fl 34233-2399, for permission to reproduce any of the contents of this article, other than for use in courses of instruction For additional information about the AAA, please visit http://aaahq.org where you can also browse the abstracts of AAA journal articles.  The Accounting Review • Issues in Accounting Education • Accounting Horizons Accounting and the Public Interest • Auditing: A Journal of Practice & Theory Behavioral Research in Accounting • Current Issues in Auditing Journal of Emerging Technologies in Accounting • Journal of Information Systems Journal of International Accounting Research Journal of Management Accounting Research • The ATA Journal of Legal Tax Research The Journal of the American Taxation Association Online Early — Preprint of Accepted Manuscript This is a PDF file of a manuscript that has been accepted for publication in an American Accounting Association journal It is the final version that was uploaded and approved by the author(s) While the paper has been through the usual rigorous peer review process for AAA journals, it has not been copyedited, nor have the graphics and tables been modified for final publication Also note that the paper may refer to online Appendices and/or Supplements that are not yet available The manuscript will undergo copyediting, typesetting and review of page proofs before it is published in its final form, therefore the published version will look different from this version and may also have some differences in content We have posted this preliminary version of the manuscript as a service to our members and subscribers in the interest of making the information available for distribution and citation as quickly as possible following acceptance The DOI for this manuscript and the correct format for citing the paper are given at the top of the online (html) abstract Once the final published version of this paper is posted online, it will replace this preliminary version at the specified DOI Do IRS Audits Deter Corporate Tax Avoidance? Jeffrey L Hoopes University of Michigan jhoopes@umich.edu Devan Mescall University of Saskatchewan mescall@edwards.usask.ca Jeffrey A Pittman Memorial University of Newfoundland jpittman@mun.ca March 2012 Editor’s note: Accepted by John Harry Evans III, with thanks to Thomas Omer for serving as editor on a previous version Submitted August 2010 Accepted April 2012 Abstract preprint We extend research on the determinants of corporate tax avoidance to include the role of Internal Revenue Service (IRS) monitoring Our evidence from large samples implies that U.S public firms undertake less aggressive tax positions when tax enforcement is stricter Reflecting its first-order economic impact on firms, our coefficient estimates imply that raising the probability of an IRS audit from 19 percent (the 25th percentile in our data) to 37 percent (the 75th percentile) increases their cash effective tax rates, on average, by nearly percentage points, which amounts to a percent increase in cash effective tax rates These results are robust to controlling for firm size and time, which determine our primary proxy for IRS enforcement, in different ways; specifying several alternative dependent and test variables; and confronting potential endogeneity with instrumental variables and panel data estimations, among other techniques accepted manuscript JEL classification: M40; G34; G32; H25 Key words: tax enforcement, tax compliance, IRS audits, taxes We appreciate comments on an earlier version of this paper, which had been circulated under the title, “IRS Monitoring, Corporate Tax Avoidance, and Governance in Public Firms”, from Sutirtha Bagchi, Beth Blankespoor, Scott Dyreng, Michelle Hanlon, David Kenchington, Clive Lennox, Russell Lundholm, Landon Mauler, Kenneth Merkley, Greg Miller, Lil Mills, Tom Omer, Ed Outslay (a discussant), Nemit Shroff, Joel Slemrod, Brian Spilker, and Gwen Yu We would like to thank the Tax Executive Institute for providing valuable insights through our survey We also thank participants at the 2009 BYU Accounting Research Symposium, the Kapnick Workshop at the University of Michigan, and the 2010 ATA Mid-Year Meeting We would also like to thank Susan Long of the Transactional Records Access Clearinghouse and Ruth Schwartz of the Statistical Information Service of the IRS for their help in gathering institutional knowledge and data regarding the IRS and its information systems Jeffrey Hoopes gratefully acknowledges funding from the Harry Jones Fund for Earnings Quality, the Paton Fellowship and the Deloitte Foundation Jeffrey Pittman acknowledges funding from the CMA Professorship and Canada’s Social Sciences and Humanities Research Council preprint accepted manuscript Introduction Recent evidence implies that natural byproducts of tough corporate tax enforcement include lower managerial diversion (e.g., Desai and Dharmapala 2006, 2009; Desai et al 2007), improved earnings quality (e.g., Hanlon et al 2011), and valuable cross-monitoring evident in debt (e.g., Guedhami and Pittman 2008) and equity (e.g., El Ghoul et al 2011) pricing However, extant research neglects to examine the more primitive issue of whether tax enforcement disciplines firms by constraining their tax avoidance We bridge this gap by providing evidence on whether public firms undertake less aggressive tax positions when the expected likelihood of an Internal Revenue Service (IRS) audit is higher Firms are understandably eager to invest in tax planning to lower their taxes since this benefits shareholders as the residual claimants (e.g., Mills 1996; Mills et al 1998) However, firms also consider the costs stemming from aggressive tax avoidance strategies, including the economically material fines, interest, and penalties that the IRS can impose for under-reporting preprint (Wilson 2009) In this paper, we evaluate whether tax avoidance subsides when corporate tax enforcement is better Although this prediction may initially appear intuitive, there are several accepted managers may not perceive IRS audits as sufficiently costly (Hanlon et al 2007), or may have little manuscript reasons to suspect that corporate tax avoidance is insensitive to IRS oversight In particular, incentive to reduce their cost (Slemrod 2004; Graham et al 2005; Armstrong et al 2011) Also, irrespective of the severity of IRS enforcement, firms may refrain from drastically lowering their taxes in order to avoid potential political costs stemming from being labeled tax aggressive (e.g., Hanlon and Slemrod 2009; Mills et al 2010) Moreover, firms may behave like wealthy individuals by increasing tax avoidance when IRS monitoring is stricter to ensure that their after-audit tax liability remains stable (Slemrod et al 2001) For example, a recent report by PricewaterhouseCoopers (2004, 6) stresses that: “Tax compliance risk also includes the risks arising from…enquiries on, or the audit of, submitted tax returns…by fiscal authorities…[T]he final agreement of a tax return often ends in a ‘horse trade’ between the taxpayer and the relevant revenue authority; it may make sense to have a number of aggressive positions in the return so that there is something to give as part of any negotiations.” In other words, companies may undertake more aggressive positions to provide some negotiating room when they perceive that an IRS audit is more likely Similarly, the IRS may share this interpretation of its bargaining process with firms Slemrod (2007, 32) recounts that: “IRS Commissioner Mark Everson (2005) testified to the President’s Advisory Panel on Tax Reform that the IRS had ‘a reputation for trading [penalties] away,’ so that it was ‘always in the interest of the noncompliant taxpayer to take an aggressive position with the Service’.” Further, if managers believe that the IRS benchmarks the firm’s tax position this year to its tax position last year, managers may surmise that deviating from avoidance strategies implemented previously may attract more intense IRS scrutiny this year Moreover, since corporate tax departments sometimes operate as profit centers with their directors having incentive to increase current year profits or decrease GAAP effective tax rates preprint (Martucci 2001; Hollingsworth 2002; Robinson et al 2010), they may be reluctant to pursue other favorable tax outcomes, such as attempting to reduce the frequency of future audits (Armstrong accepted an IRS audit when they consider their tax position to be highly defensible For example, Hanlon et manuscript et al 2011; Slemrod 2004) Adding tension to our analysis, managers may also discount the cost of al (2007) document that of the firms audited in their sample, 45 percent had no proposed tax deficiency, and of those firms with a proposed deficiency identified by the IRS, only 60 percent of these amounts were later paid, suggesting that even conditional upon occurring, these audits are sometimes not very costly to firms In short, it remains an empirical question whether strict IRS monitoring deters corporate tax avoidance To address our research question, we primarily gauge corporate tax avoidance with firms’ cash effective tax rates, which is the amount of cash taxes paid by the firm scaled by its pre-tax income We follow Guedhami and Pittman (2008) and Hanlon et al (2011) by relying on data from the Transactional Records Clearinghouse (TRAC)⎯a nonpartisan research watchdog affiliated with Syracuse University that publicly releases statistics on the performance of many federal agencies according to the government’s own real data⎯to measure on-the-ground IRS enforcement This data source suits our focus on how the agency actually exercises its authority to enforce tax compliance Given our interest in capturing the ex ante threat of an IRS audit according to managers’ perceptions rather than its actual incidence, we mainly specify corporate tax enforcement using a TRAC report on time-varying audit probabilities across the eight nominal asset levels that the IRS uses in aggregating its auditing data.1 We also conduct a survey of managers, which validates our primary test variable in that a substantial number of managers use historical data provided by the tax authority (which is the source of the TRAC data) to gauge tax enforcement Our analysis spans from the earliest (1992) to the latest (2008) year that IRS audit rate data are available Analyzing this long timeframe is constructive for identification since corporate tax enforcement was ascending at some points during this period and descending at others preprint However, we caution that this time-series variation is imperfect for our purposes given that IRS enforcement was generally declining during the 17 years under study, with the rise in accepted More positively, the source of variation in IRS audit rates that reflect firm size, time, and manuscript enforcement predominantly occurring within a short period late in the 1992-2008 timeframe This data is graphically displayed, and the asset size categories are listed, in Panel A of Figure Our specification assumes that managers form rational expectations about the probability that their firm will be audited with actual IRS audit rates representing unbiased estimates of their unobservable perceptions Although we initially assume that any errors that managers make in predicting future IRS audit rates are unsystematic (i.e., any deviations from perfect foresight are random), we later relax this assumption by analyzing whether the impact of lagged IRS audit rates on corporate tax avoidance is sensitive to gauging expectations with historical rates We also examine whether our core evidence holds when we measure IRS monitoring with lead audit rates to reflect that it can take the agency more than a year to finish its investigation Data constraints force extant cross-country research to measure corporate tax enforcement with indices that are constant over time; e.g., Dyck and Zingales (2004), Haw et al (2004), Morck and Yeung (2005), and Desai et al (2007) interactions between them⎯factors generally considered removed from management choice⎯is likely exogenous.2 We find that closer IRS monitoring limits corporate tax avoidance Since IRS audit rates are aggregated by firm size and time, we triangulate our results to help dispel concern that the impact of either of these variables is spuriously behind our evidence However, we continue to observe an inverse relation between IRS enforcement and tax avoidance when we re-specify the controls for both size and time in several ways Economically, our coefficient estimates translate into firms’ cash effective tax rates rising by, on average, almost percentage points (a percent increase in relative terms) when the probability that the firm will be subject to an IRS audit increases from 19 percent (the 25th percentile in our data) to 37 percent (the 75th percentile) In supplementary analysis, we isolate whether the role that active IRS monitoring plays in constraining aggressive tax planning hinges on the quality of firm-level governance This both helps triangulate our main result and complements recent evidence on the interplay between preprint governance and taxation (e.g., Desai and Dharmapala 2006) We examine whether governance characteristics⎯specifically, the equity stakes held by institutional investors, Gompers et al.’s accepted avoidance Prior research implies that self-dealing managers can exploit complex tax planning, manuscript (2003) index, and external auditor choice⎯shape the link between corporate tax enforcement and under the pretext that lowering taxes benefits shareholders, to hide their diversionary activities by suppressing information essential for monitoring (e.g., Desai and Dharmapala 2006; Graham and Tucker 2006; Desai et al 2007) It follows that IRS monitoring will matter more when the firm’s own governance structures are lax In evidence consistent with this perspective, we find that the impact of IRS audit rates on corporate tax avoidance is larger in poorly-governed firms Collectively, our research suggests that IRS monitoring looms large in preventing corporate tax avoidance, particularly when firm-level governance is weaker However, firms can pursue corporate policies such as acquisitions, divestitures, and share repurchases that materially affect their size None of our core results are sensitive to confronting this potential source of endogeneity with, for example, instrumental variables and panel data estimations By documenting that tougher IRS monitoring deters firms from pursuing aggressive tax strategies, we contribute to extant research by responding to calls for evidence that helps explain corporate tax avoidance (Shackelford and Shevlin 2001; Graham 2008; Desai and Dharmapala 2010) Our analysis also provides empirical support for theory aimed at understanding the intersection between corporate tax behavior and tax enforcement (i.e., Crocker and Slemrod 2005; Shackelford et al 2008).3 We also complement recent evidence that the IRS plays a valuable (nontax) external monitoring role by focusing on managers’ perceptions, rather than investors’ Although it would be premature at this early stage to propose policy prescriptions, such as recommending that the government should devote more resources to corporate tax enforcement, we help fill another void by providing some insight on the tax revenue implications of IRS monitoring (Hanlon and Heitzman 2010) The rest of this paper is organized as follows Section motivates the testable prediction Section outlines our research design Section covers our evidence Section concludes Motivation preprint accepted manuscript In this section, we outline prior research to develop the intuition that strict IRS monitoring lowers corporate tax avoidance There is considerable theory and empirical evidence that tough IRS enforcement improves individual tax compliance (e.g., Allingham and Sandmo 1972; Alm et al 1992; and Slemrod et al 2001) However, Cowell (2004) and Kopczuk and Slemrod (2006) stress that extant empirical research on this issue for firms remains scarce.4 Although there is extensive evidence on individuals’ responses to the severity of tax enforcement, prior research seldom examines its importance to corporate tax avoidance However, there are some exceptions Most notably, Rice (1992) relies on IRS data to provide evidence that income tax compliance is higher for public firms and firms belonging to regulated industries, and lower for firms located in tax havens Corroborating that newly public firms experience a permanent increase in tax pressure, Pagano et al (1998) estimate that these firms pay percent more in taxes the year after their initial public offering, which they attribute to the resulting greater accounting transparency and closer scrutiny from tax authorities constraining firms from eluding taxes While prior research supports that rigorous IRS monitoring improves individual tax compliance, this evidence does not necessarily imply that a similar link prevails between IRS enforcement and the firm Dyreng et al (2008) show that effective tax rates (ETRs) are a choice variable, suggesting that firms can strategically avoid taxes over the long run Similarly, Mills (1996) and Mills et al (1998) report that firms that spend more on tax planning enjoy lower tax burdens At the executive level, prior research documents that annual bonuses (Hanlon et al 2007), equity-based incentives (Desai and Dharmapala 2006), and the compensation paid to CFOs and CEOs (Rego and Wilson 2010) affect corporate tax aggressiveness In focusing on activities within corporate tax departments, more recent evidence supports that tax director incentives lead to lower GAAP ETRs, unlike their minimal impact on firms’ cash ETRs (Armstrong et al 2011; Robinson et al 2010) Moreover, Dyreng et al (2010) find that individual managers’ characteristics affect corporate tax planning In contrast, we focus on the other side of the equation by providing evidence on whether the government expending more resources on enforcement constrains firms⎯and their managers⎯from aggressively reducing taxes In short, we extend research on the determinants of corporate tax avoidance to include IRS monitoring preprint In analyzing confidential corporate tax returns, Mills and Sansing (2000) find that the probability that the government will audit a transaction is higher for firms that generate book-tax accepted Department of the Treasury 1999) suggest that firms can deflect IRS attention by narrowing the manuscript differences Prior research (e.g., Mills 1998) and federal government publications (e.g., U.S gap between their financial reporting and taxable incomes IRS guidelines specifically instruct their agents to investigate when book income seriously diverges from taxable income, reinforcing both tax advisors’ (Cloyd 1995) and corporate managers’ (Cloyd et al 1996) perceptions that conformity leads to lower tax audit costs Although Slemrod et al (2001) find that individuals pay more in taxes when they face higher audit probabilities, this result does not hold for their subsample of wealthy individuals, who actually decrease their level of tax compliance given a high probability of audit Since sophisticated firms may behave more like wealthy individuals than like the average individual, the general finding of a positive relation between tax compliance and IRS auditing may not extend to firms Accordingly, analyzing firm reactions to variations in IRS monitoring is important in its own right References Allingham, M., and A Sandmo 1972 Income tax evasion: A theoretical analysis Journal of Public Economics 1: 323-338 Alm, J., B Jackson, and M McKee 1992 Estimating the determinants of taxpayer compliance with experimental data National Tax Journal 45: 107-114 Armstrong, C., J Blouin, and D Larcker 2011 The incentives for tax planning Journal of Accounting and Economics, forthcoming Ashbaugh-Skaife, H., D Collins, and R LaFond 2006 The effects of corporate governance on firms’ credit ratings Journal of Accounting and Economics 42: 203-243 Associated Press 2009 Deficit could cause more IRS audits, experts say July 16 Ayers, B C., J Jiang, and S K Laplante 2009 Taxable income as a performance measure: The effects of tax planning and earnings quality Contemporary Accounting Research 26: 15-54 ———, S K Laplante, and S McGuire 2010 Credit ratings and taxes: the effect of book/tax differences on ratings changes Contemporary Accounting Research 27: 359-402 Baik, B., J.-K Kang, and J.-M Kim 2010 Local institutional investors, information asymmetries, and equity returns Journal of Financial Economics 97: 81-106 Bagchi, S 2012 Are republican administrations light on tax enforcement?: A look at the IRS Working paper, University of Michigan Beck, P., and P Lisowsky, P 2011 Financial statement incentives and benefits of voluntary realtime tax audits Working paper, University of Illinois Becker, G 1978 Crime and punishment: An economic approach The Journal of Political Economy 76:2 169-217 Beron, K J., H V Tauchen, and A D Witte 1992 The effect of audits and socioeconomic variables on compliance In, Why People Pay Taxes, edited by J Slemrod, 67-89 Ann Arbor, MI: University of Michigan Press Blouin, J., C Gleason, L Mills, and S Sikes 2010 What can we learn about uncertain tax benefits from FIN 48? Working paper, University of Texas at Austin Bushee, B 1998 The influence of institutional investors on myopic R&D investment behavior The Accounting Review 73: 305-333 Chen, S., X Chen, Q Cheng, and T Shevlin 2010 Are family firms more tax aggressive than nonfamily firms? Journal of Financial Economics 95: 41-61 Chen, X., J Harford, and K Li 2007 Monitoring: Which institutions matter? Journal of Financial Economics 86: 279-305 Cloyd, B 1995 The effects of financial accounting conformity on recommendations of tax preparers The Journal of the American Taxation Association 17: 50-70 ———, J Pratt, and T Stock 1996 The use of financial accounting choice to support aggressive tax positions: Public and private firms Journal of Accounting Research 34: 23-43 Cowell, F 2004 Carrots and sticks in enforcement In The crisis in tax administration, edited by H Aaron and J Slemrod, 230-275 Washington, D.C.: Brookings Institution Press Cremers, M K J., and V B Nair 2005 Governance mechanisms and equity prices Journal of Finance 60: 2859-2894 preprint accepted manuscript 37 Crocker, K., and J Slemrod 2005 Corporate tax evasion with agency costs Journal of Public Economics 89: 1593-1610 Dechow, P., and I Dichev 2002 The quality of accruals and earnings: The role of accrual estimation errors The Accounting Review 77: 35-59 Desai, M 2005 The degradation of corporate profits Journal of Economic Perspectives 19: 171-192 ———, and D Dharmapala 2006 Corporate tax avoidance and high-powered incentives Journal of Financial Economics 79: 145-179 ———, and D Dharmapala 2009 Corporate tax avoidance and firm value Review of Economics and Statistics 91: 537-546 ———, and D Dharmapala 2010 Taxation and corporate governance: An economic approach In Tax and Corporate Governance, edited by W Schoen Springer-Verlag ———, A Dyck, and L Zingales 2007 Theft and Taxes Journal of Financial Economics 84: 591-623 ———, and J Hines 2002 Expectations and expatriations: Tracing the causes and consequences of corporate inversions National Tax Journal 55: 409-440 Dyck, A., A Morse, and L Zingales 2010 Who blows the whistle on corporate fraud? Journal of Finance 65: 2213-2253 ———, and L Zingales 2004 Private benefits of control: An international comparison Journal of Finance 59: 537-600 Dyreng, S D., M Hanlon, and E L Maydew 2008 Long-run corporate tax avoidance The Accounting Review 83: 61-82 ———, M Hanlon, and E L Maydew 2010 The effects of executives on corporate tax avoidance The Accounting Review 85: 1163-1189 El Ghoul, S., O Guedhami, and J A Pittman 2011 The role of IRS monitoring in equity pricing in public firms Contemporary Accounting Research 28: 643-674 ———, O Guedhami, Y Ni, J A Pittman, and S Saadi 2012 Does information asymmetry matter to equity pricing? Evidence from firms’ geographic location Contemporary Accounting Research, forthcoming Erickson, M., M Hanlon, and E L Maydew 2004 How much will firms pay for earnings that not exist? Evidence of taxes paid on allegedly fraudulent earnings The Accounting Review 79: 387-408 Everson, M 2005 Testimony given to the President’s Advisory Panel on Federal Tax Reform Washington, DC March Fama, E., and K French 1997 Industry costs of equity Journal of Financial Economics 43: 153-193 Francis, J., and C Lennox 2010 Selection models in accounting research Working paper, University of Missouri at Columbia Frank, M M., L Lynch, and S Rego 2009a Tax reporting aggressiveness and its relation to aggressive financial reporting The Accounting Review 84: 467-496 ———, L Lynch, and S Rego 2009b Are financial and tax reporting aggressiveness reflective of broader corporate policies? Working paper, University of Iowa preprint accepted manuscript 38 Gleason, C A., and L F Mills 2002 Materiality and contingent tax liability reporting The Accounting Review 77: 317-342 ———, and L F Mills 2010 Do auditor-provided tax services improve the estimate of tax reserves? Contemporary Accounting Research, forthcoming Gompers, P., J Ishii, and A Metrick 2003 Corporate governance and equity prices The Quarterly Journal of Economics 118: 107-155 Graham, J R 2008 Taxes and corporate finance In Handbook of Corporate Finance; Empirical Corporate Finance, edited by B E Eckbo Amsterdam: Elsevier Science ———, M Hanlon, and T Shevlin 2011 Real effects of accounting rules: Evidence from multinational firms' investment location and profit repatriation decisions Journal of Accounting Research 49: 137-185 ———, and C Harvey 2001 The theory and practice of corporate finance: Evidence from the field Journal of Financial Economics 61: 187-243 ———, C Harvey, and S Rajgopal 2005 The economic implications of corporate financial reporting Journal of Accounting and Economics 40: 3-73 ———, and A Tucker 2006 Tax shelters and corporate debt policy Journal of Financial Economics 81: 563-594 Griliches, Z., and J A Hausman 1986 Errors in variables in panel data Journal of Econometrics 31: 93-118 Guedhami, O., and J A Pittman 2006 Ownership concentration in privatized firms: The role of disclosure standards, auditor choice, and auditing infrastructure Journal of Accounting Research 44: 889-929 ———, Guedhami, O., and J A Pittman 2008 The importance of IRS monitoring to debt pricing in private firms Journal of Financial Economics 90: 38-58 Hail, L., and C Leuz 2006 International differences in the cost of equity capital: Do legal institutions and securities regulation matter? Journal of Accounting Research 44: 485-531 Hanlon, M., and S Heitzman 2010 A review of tax research Journal of Accounting and Economics 50: 127-178 ———, J Hoopes, and N Shroff 2011 The effect of tax enforcement on financial reporting quality Working paper, University of Michigan ———, L Mills, and J Slemrod 2007 An empirical examination of corporate tax noncompliance In Taxing Corporate Income in the 21st Century, edited by A Auerbach, J Hines, and J Slemrod New York, NY: Cambridge University Press ———, and J Slemrod 2009 What does tax aggressiveness signal? Evidence from stock price reactions to news about tax shelter involvement Journal of Public Economics 93: 126-141 Hartzell, J., and L Starks 2003 Institutional investors and executive compensation Journal of Finance 58: 2351-2374 Hasegawa, M., J Hoopes, R Ishida, and J Slemrod 2012 The effect of public disclosure on reported taxable income: Evidence from individuals and corporations in Japan Working paper, University of Michigan preprint accepted manuscript 39 Haw, I-M., B Hu, L-S Hwang, and W Wu 2004 Ultimate ownership, income management, and legal and extra-legal institutions Journal of Accounting Research 42: 423-462 Hilary, G., and K W Hui 2009 Does religion matter in corporate decision making in America? Journal of Financial Economics 29: 455-473 Hollingsworth, T 2002 Manufacturers Alliance/MAPI Survey of Corporate Tax Departments— 4th Edition Arlington, VA: Manufacturers Alliance/MAPI Internal Revenue Service 2008 Internal Revenue Service Data Book, 2008 Washington, DC: Internal Revenue Service ——— 2007 Internal Revenue Service Data Book, 2007 Washington, DC: Internal Revenue Service ——— 2003 Report to Congress: IRS Tax Compliance Activities Department of the Treasury Washington, DC: Internal Revenue Service Ivashina, V., V B Nair, A Saunders, and N Massoud 2004 The role of banks in takeovers Working Paper, New York University Kim, J., Y Li, and L Zhang 2011 Corporate tax avoidance and stock price crash risk: Firm-level analysis Journal of Financial Economics 100: 639-662 Koenker, R., and K.F Hallock 2001 Quantile regression The Journal of Economic Perspectives 15: 143-156 Kopczuk, W., and J Slemrod 2006 Putting firms into optimal tax theory American Economic Review 96: 130-134 Larcker D., S Richardson, and I Tuna 2007 Corporate governance, accounting outcomes, and organizational performance The Accounting Review 82: 963-1008 ———, and T Rusticus, T 2009 On the use of instrumental variables in accounting research Journal of Accounting and Economics 49: 186-205 Lennox, C., P Lisowsky, and J A Pittman 2010 Tax aggressiveness and accounting fraud Working paper: Nanyang Technological University, University of Illinois at UrbanaChampaign, and Memorial University Lev, B., and D Nissim 2004 Taxable income, future earnings and equity values The Accounting Review 79: 1039–74 Lisowsky, P., L Robinson, and A Schmidt 2011 Do publicly disclosed tax reserves tell us about privately disclosed tax shelter activity? Working paper, University of Illinois Loughran, T 2007 Geographic dissemination of information Journal of Corporate Finance 13: 675694 ———, 2008 The impact of firm location on equity issuance Financial Management 37: 1-21 ———, and P Schultz 2005 Liquidity: Urban versus rural firms Journal of Financial Economics 78: 341-374 Martucci, S 2001 Fortune 1000 tax departments streamlining to handle strategy role Global Finance: November Mankiw, N.G., and M Weinzierl 2010 The optimal taxation of height: A case study of utilitarian income redistribution American Economic Journal: Economic Policy 2: 155-176 McGill, G., and E Outslay 2002 Did Enron pay taxes? Using accounting information to decipher tax status Tax Notes 96 preprint accepted manuscript 40 Mills, L 1998 Book-tax differences and Internal Revenue Service adjustments Journal of Accounting Research 36: 343-356 ——— 1996 Corporate tax compliance and financial reporting National Tax Journal 49: 421-435 ———, M Erickson, and E Maydew 1998 Investments in tax planning The Journal of the American Taxation Association 20: 1-20 ———, and K Newberry 2001 The influence of tax and nontax costs on book-tax reporting differences: Public and private firms The Journal of the American Taxation Association 23: 1-19 ———, S Nutter, and C Schwab 2010 The Effect of Political Sensitivity and Political Power on Tax Avoidance: Evidence from Federal Contractors Working paper, University of Texas ———, and R C Sansing 2000 Strategic tax and financial reporting decisions: Theory and evidence Contemporary Accounting Research 17: 85-106 Morck, R., and B Yeung 2005 Dividend taxation and corporate governance Journal of Economic Perspectives 19: 163-180 Pagano, M., F Panetta, and L Zingales 1998 Why companies go public? An empirical analysis Journal of Finance 53: 27-64 Phillips, J D 2003 Corporate tax-planning effectiveness: The role of compensation-based incentives The Accounting Review 78: 847-874 ———, M Pincus, and S Rego 2003 Earnings management: New evidence based on the deferred tax expense The Accounting Review 78: 491–522 Pirinsky, C., and Q Wang 2010 Does corporate headquarters location matter for stock returns? Journal of Finance 61: 1991-2015 PricewaterhouseCoopers 2004 Tax risk management www.pwc.co.za/en/assets/pdf/pwc-tax-risk- management-guide.pdf ——— preprint 2006 PricewaterhouseCoopers LLP names John Petrella managing director in the firm’s Washington national tax services practice GlobeNewswire August 24 Rego, S., and R Wilson 2010 Executive compensation, tax reporting aggressiveness, and future firm performance Working paper, University of Iowa Rice, E 1992 The corporate tax gap: Evidence on tax compliance by small corporations In Why People Pay Taxes: Tax Compliance and Enforcement, edited by J Slemrod,125-161 Ann Arbor, MI: University of Michigan Press Robinson, J R., S A Sikes, and C D Weaver 2010 Performance measurement of corporate tax departments The Accounting Review 85: 1035–1064 Roe, M., and H Jackman 2009 Public and private enforcement of securities laws: Resource-based evidence Journal of Financial Economics 93: 207-238 Schneider, C 2005 IRS to Audit More S Corporations CFO.com July 29 Available at: http://www.cfo.com/article.cfm/4242335/c_4241354?f=home_todayinfinance Scholes, M., M Wolfson, M Erickson, E Maydew, and T Shevlin 2008 Taxes and Business Strategy (Fourth Edition ed.) Upper Saddle River, NJ: Prentice Hall Seidman, J.K., and B Stomberg 2011 Why are option compensation and tax sheltering negatively related? Working paper, University of Texas accepted manuscript 41 Shackelford, D., and T Shevlin 2001 Empirical tax research in accounting Journal of Accounting and Economics 31: 321-387 ———, J Slemrod, and J Sallee 2008 A unifying model of how the tax system and generally accepted accounting principles affect corporate behavior Working paper, University of North Carolina Shleifer, A., and R W Vishny 1986 Large shareholders and corporate governance Journal of Political Economy 94: 461-488 Slemrod, J 2004 The economics of corporate tax selfishness National Tax Journal 57: 877-899 ——— 2007 Cheating ourselves: The economics of tax evasion Journal of Economic Perspectives 21: 25-48 ———, M Blumenthal, and C Christian 2001 Taxpayer response to an increased probability of audit: evidence from a controlled experiment in Minnesota Journal of Public Economics 79: 455483 ———, and V Venkatesch 2002 The Income Tax Compliance Cost of Large and Midsize Businesses A Report to the IRS LMSB Division ———, and S Yitzhaki 2002 Tax avoidance, evasion, and administration In Handbook of Public edited by In A Auerbach and M Feldstein, 1423-1470 Amsterdam: Economics Elsevier Science Stock, J., and M Watson 2002 Introduction to Econometrics 2nd Edition Addison Wesley Tax Executive Institute 2003 Linda B Burke resigns as LMSB Division Counsel Tax Executive July ——— 2007 Minutes of TEI - LMSB liaison meeting: February 12, 2007 (Tax Executives Institute, large and mid-size business) Tax Executives March Transactional Records Access Clearinghouse 2005 IRS History Available at: http://trac.syr.edu/tracirs/atwork/current/irsHistory.html U.S Department of the Treasury 1999 The problem of corporate tax shelters: Discussion, analysis and legislative proposals Washington, DC: Government Printing Office July Wallace, R., and C Mellor 1988 Nonresponse bias in mail accounting surveys: A pedagogical note British Accounting Review 20: 131-139 Wilson, R 2009 An examination of corporate tax shelter participants The Accounting Review 84: 969-999 Yan, X., and Z Zhang 2009 Institutional investors and equity returns: Are short-term institutions better informed? Review of Financial Studies 22: 893-924 preprint accepted manuscript 42 Figure IRS Audit Coverage Panel A IRS Audit Coverage for Corporations, by Asset Size, 1992-2008 Percentage of Returns Audited 60.00% 50.00% IRS Asset Size 40.00% >250,000,000 250,000,000 100,000,000 50,000,000 10,000,000 5,000,000 1,000,000 250,000 30.00% 20.00% 10.00% 0.00% Panel B Number of Corporate Audits Complete in IRS Fiscal Year, by Asset Size, 1992-2008 Number of Field Examinations 7,000 6,000 5,000 4,000 3,000 preprint accepted manuscript >250,000,000 250,000,000 100,000,000 50,000,000 2,000 10,000,000 1,000 Notes: These graphs displays the audit probability (Panel A) and the numerator (Panel B) of audit probability, for firms in specific IRS asset classes using data obtained from the Transactional Records Access Clearinghouse In Panel A, each line represents the proportion of corporate tax audits completed in the given IRS fiscal year t for that asset class, divided by the number of corporate tax returns in IRS calendar year t-1 for that asset class In Panel B, the lines represent the number of face-to-face IRS audits conducted each year in each IRS asset size pool Panels B excludes asset sizes below $10,000,000 in assets, as including them makes the variance in the larger (and more relevant) asset size class groups almost indiscernible 43 Figure Effects of IRS Tax Enforcement on Different Quantiles of CASH ETR 0.25 0.2 AUDIT PROBABILITY 0.15 0.1 0.05 -0.05 q5 q10 q15 q20 q25 q30 q35 q40 q45 q50 q55 q60 q65 q70 q75 q80 q85 q90 q95 -0.1 -0.15 -0.2 -0.25 Quantile Coefficient on AUDIT PROBABILITY Lower 95th Percentile Confidence Bound preprint Notes: This figure depicts the quantile estimates obtained from estimating this equation: accepted manuscript CASH ETR = β0 + β1AUDIT PROBABILITY + β2 X + Year Fixed Effects + εit 5th, 10th, 15th, 20th, 25th, 30th, 35th 40th, 45th, 50th, on the 55th, 60th, 65th, 70th, 75th, 80th, 85th, 90th, and 95th quantiles of the distribution of CASH ETR Coefficient values are on the Y axis and percentiles of the distribution are on the X axis The upper and lower 95th percentile confidence intervals surround the coefficient estimates AUDIT PROBABILITY is the number of face to face corporate audits completed in IRS fiscal year t in a given IRS asset size category divided by total number of 1120 returns filed in calendar year t-1, in an IRS asset size category CASH ETR is cash taxes paid scaled by pre-tax income X represents a vector of control variables that are defined in Appendix 2: Log(ASSETS), LEVERAGE, INVENTORY INTENSITY, R&D INTENSITY, CAPITAL EXPENDITURES, ROA, NOL, ΔNOL, FOREIGN INCOME and BIG FOUR 44 Table Sample Selection Panel A Number of Observations Surviving Each Sample Screen Sample Selection Firm-Year Observations Firms with data on assets Firms incorporated in the US Firms located in a US state Firms with positive net income less special items Firms with the data required for all control variables 173,231 143,151 140,489 87,961 66,310 Panel B Number of Observations for Each IRS Asset Level from Compustat Sample Year 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Total Less than $250,000 - $1 $250,000 Million 5 1 2 34 24 14 14 14 12 8 7 9 155 148 146 122 107 102 86 63 61 72 58 58 51 36 34 26 24 18 1212 199 182 190 173 172 143 117 101 92 82 84 79 65 56 45 40 32 1852 S10 - $50 $50 - $100 $100 - $250 $250 Million or Million Million Million more 840 895 922 900 987 842 629 564 453 373 359 349 370 329 293 261 227 9593 $1 - $5 Million $5 - $10 Million 507 541 604 611 645 607 537 438 337 286 274 251 269 242 212 189 179 6729 593 675 769 761 852 874 776 665 565 479 480 481 552 510 485 436 386 10339 1449 1558 1783 1876 2078 2145 2107 2095 2035 1845 1931 2058 2777 2843 2873 2654 2289 36396 preprint accepted manuscript Total 3765 4016 4407 4443 4849 4706 4239 3932 3560 3131 3193 3279 4078 4023 3944 3611 3134 66310 Notes: This table reports the distribution of the sample by calendar year and asset level in Panel A and the screening process applied to assemble the sample in Panel B 45 Table Descriptive Statistics Panel A Distributional Statistics Variable Mean STD P25 P50 P75 Obs AUDIT PROBABILITY 0.29 0.13 0.19 0.29 0.37 66310 CASH ETR 0.27 0.23 0.08 0.25 0.37 66310 NON-CONFORMING CASH ETR 0.27 0.27 0.06 0.20 0.38 59205 3-YEAR CASH ETR 0.30 0.19 0.18 0.29 0.38 13292 GAAP ETR 0.32 0.16 0.28 0.36 0.39 62531 DISTRICT/SIZE/TIME AUDIT PROBABILITY 0.34 0.19 0.19 0.29 0.44 37631 DISTRICT/TIME AUDIT PROBABILITY 0.02 0.01 0.02 0.02 0.03 37631 Log(ASSETS) 5.82 2.14 4.32 5.79 7.26 66310 Log(SALES) 5.60 2.03 4.17 5.58 6.98 66310 Log(MVE) 5.50 2.17 3.99 5.49 6.98 56563 0.01 0.15 0.33 66310 0.00 0.08 0.23 66310 LEVERAGE INVENTORY INTENSITY R&D INTENSITY CAPITAL EXPEDITURES ROA NOL ΔNOL FOREIGN INCOME BIG FOUR 0.15 0.19 preprint 0.22 0.26 0.02 0.05 0.00 0.00 0.02 66310 0.07 0.09 0.02 0.04 0.08 66310 0.07 0.13 66310 0.00 0.00 66310 0.09 0.09 0.03 accepted 0.23 0.42 0.00 manuscript 0.00 0.07 0.00 0.00 0.00 66310 0.01 0.03 0.00 0.00 0.00 66310 0.82 0.38 1.00 1.00 1.00 66310 46 Panel B Pair-Wise Pearson Correlations of Variables 1 AUDIT PROBABILITY 10 11 18 19 0.58 0.05 0.04 -0.02 0.15 0.55 -0.05 0.89 0.86 0.19 -0.05 -0.13 -0.08 0.05 0.16 -0.05 0.19 0.16 0.07 0.10 -0.02 0.03 -0.02 -0.01 0.10 -0.01 0.16 0.20 0.26 -0.04 0.01 0.16 0.01 0.16 0.10 0.03 0.32 0.03 0.00 -0.02 0.11 0.20 0.00 0.32 0.41 0.38 0.10 -0.02 0.08 0.07 0.02 -0.02 0.06 0.10 0.08 NON-CONFORMING CASH ETR 0.03 0.57 3-YEAR CASH ETR 0.04 0.57 0.43 GAAP ETR 0.15 0.33 0.26 0.31 DISTRICT/SIZE/TIME AUDIT PROBABILITY Log(ASSETS) 0.81 0.08 0.00 0.02 0.13 0.20 0.02 0.02 0.03 0.00 0.23 0.66 0.06 -0.03 -0.03 0.14 0.63 -0.07 Log(SALES) 0.61 0.08 0.01 0.01 0.19 0.60 -0.06 0.89 10 Log(MVE) 11 LEVERAGE 12 16 17 0.02 0.01 0.12 -0.02 -0.05 0.04 -0.03 -0.02 0.01 -0.10 -0.22 1 1 -0.10 0.04 0.21 0.10 0.02 -0.09 0.03 -0.22 -0.04 -0.19 0.01 -0.13 -0.08 -0.06 -0.07 -0.09 -0.14 0.04 -0.12 -0.12 0.06 -0.19 -0.03 14 CAPITAL EXPENDITURES 0.00 -0.05 -0.06 -0.04 0.04 -0.04 0.02 -0.09 -0.04 0.02 -0.13 -0.05 0.24 0.06 -0.01 -0.11 0.01 -0.19 -0.06 0.07 -0.10 -0.13 -0.14 -0.12 -0.09 -0.09 -0.01 -0.05 0.00 -0.02 0.08 0.07 0.05 0.04 0.10 0.07 -0.04 0.11 0.10 0.10 17 ΔNOL 18 FOREIGN INCOME 19 BIG FOUR 15 13 R&D INTENSITY 16 NOL 14 12 INVENTORY INTENSITY 15 ROA 13 CASH ETR DISTRICT/TIME AUDIT PROBABILITY preprint 1 0.16 0.02 -0.02 -0.21 0.09 0.05 0.13 accepted manuscript Notes: This table presents distributional statistics and Pearson correlation coefficients between the regression variables for the 66,310 firm-year observations used in the hypotheses tests Panel A includes the mean, first quartile, median, third quartile, and standard deviation Panel B reports the Pearson pair-wise correlations with boldface indicating statistical significance at the 1% level AUDIT PROBABILITY is the number of face to face corporate audits completed in IRS fiscal year t in a given IRS asset size divided by total number of 1120 returns filed in calendar year t-1, in an IRS asset size CASH ETR is cash taxes paid scaled by pretax income NON-CONFORMING CASH ETR is the cash taxes paid scaled by cash flows from operations The 3-YEAR CASH ETR is the sum of year t through year t+2's cash taxes paid scaled by the sum of pretax income over the same time period GAAP ETR is the total income tax expense scaled by pretax income DISTRICT/SIZE/TIME AUDIT PROBABILITY is the number of corporate tax audits completed in IRS fiscal year t in a given IRS district for a given IRS asset class group, divided by the number of corporate tax returns received in that same district and IRS asset size group in IRS calendar year t-1 DISTRICT/SIZE/TIME AUDIT PROBABILITY is the number of corporate tax audits completed in IRS fiscal year t in a given IRS district, divided by the number of corporate tax returns received in that same district in IRS calendar year t-1 Log(ASSETS) is the natural log value of total firm assets Log(SALES) is the natural log value of total sales Log(MVE) is the natural log value of the market value of equity of the firm LEVERAGE is the total long term debt scaled by lagged assets INVENTORY INTENSITY is the total inventory scaled by lagged assets R&D INTENSITY is the research and development expense scaled by lagged assets CAPITAL EXPENDITURES is the capital expenditures of the firm, scaled by lagged assets ROA is the pretax income divided by assets NOL is an indicator variable coded if firm has an tax loss carry forward in the prior year, otherwise ΔNOL is the difference between year t and year t-1's tax loss carry-forward, scaled by lagged assets FOREIGN INCOME is the foreign income of the firm scaled by lagged assets BIG FOUR reflects whether the firm appoints a Big Four auditor in year t 47 Table Corporate Tax Avoidance (CASH ETR) and IRS Monitoring Alternative Size Controls Baseline Asset Deciles Log(SALES) Log(MVE) (1) AUDIT PROBABILITY SIZE (2) (3) (4) 0.104*** (6.19) 0.001 (1.04) 0.114*** (6.30) 0.036** (2.27) 0.008*** (6.63) 0.028* (1.68) 0.008*** (7.31) -0.079*** (-14.26) 0.034*** (4.03) -0.296*** (-9.58) -0.077*** (-5.60) -0.141*** (-9.08) -0.058*** (-18.18) 0.115*** (7.86) -0.064 (-1.28) 0.017*** (4.36) 0.317*** (30.57) Yes Yes No -0.080*** (-14.40) 0.034*** (4.07) -0.309*** (-10.08) -0.088*** (-6.36) -0.136*** (-8.83) -0.056*** (-17.62) 0.104*** (7.14) -0.051 (-1.03) 0.007* (1.77) 0.290*** (26.63) Yes Yes Yes -0.079*** (-14.24) 0.031*** (3.71) -0.279*** (-9.00) -0.073*** (-5.31) -0.147*** (-9.50) -0.058*** (-18.39) 0.113*** (7.70) -0.104** (-2.09) 0.010** (2.57) 0.320*** (30.79) Yes Yes No 66,310 0.067 66,310 0.071 66,310 0.069 -0.082*** (-13.55) 0.059*** (6.26) -0.313*** (-9.31) -0.078*** (-4.95) -0.163*** (-9.48) -0.055*** (-16.69) 0.135*** (8.39) -0.133** (-2.54) 0.008* (1.93) 0.347*** (21.28) Yes Yes No 0.006*** (7.49) -0.002*** (-6.00) -0.078*** (-14.05) 0.032*** (3.78) -0.301*** (-9.74) -0.061*** (-4.41) -0.143*** (-9.22) -0.058*** (-18.20) 0.111*** (7.55) -0.034 (-0.69) 0.015*** (3.96) 0.327*** (33.68) No Yes No 0.075*** (5.31) 0.003** (2.41) -0.001* (-1.70) -0.079*** (-14.27) 0.033*** (3.97) -0.299*** (-9.70) -0.061*** (-4.39) -0.144*** (-9.24) -0.058*** (-18.24) 0.110*** (7.46) -0.043 (-0.87) 0.015*** (4.05) 0.315*** (31.45) No Yes No 56,563 0.075 66,310 0.056 66,310 0.056 TREND LEVERAGE INVENTORY INTENSITY R&D INTENSITY CAPITAL EXPENDITURES ROA NOL ΔNOL FOREIGN INCOME BIG FOUR Constant Year Fixed Effects Industry Fixed Effects Asset Decile Fixed Effects Observations R-squared Alternative Time Controls Without AUDIT With TREND TREND PROBABILITY (5) (6) (7) preprint accepted manuscript Panel Data Estimation Fixed Effects Random Effects (8) (9) (7.45) 0.001 (1.02) 0.000 (1.03) -0.079*** (-14.25) 0.035*** (4.21) -0.301*** (-9.75) -0.057*** (-4.15) -0.144*** (-9.30) -0.059*** (-18.51) 0.107*** (7.30) -0.050 (-1.01) 0.017*** (4.60) 0.309*** (31.44) No Yes No 0.098*** (5.67) 0.019*** (9.21) 0.110*** (7.56) 0.006*** (5.21) -0.049*** (-9.23) -0.007 (-0.60) 0.116** (2.19) 0.085*** (5.86) -0.323*** (-23.53) -0.049*** (-16.83) 0.037*** (2.62) -0.694*** (-12.86) 0.018*** (4.39) 0.182*** (16.88) Yes No No -0.064*** (-15.11) 0.050*** (7.45) -0.172*** (-6.67) -0.013 (-1.13) -0.276*** (-23.39) -0.056*** (-22.85) 0.056*** (4.33) -0.384*** (-8.58) 0.012*** (3.82) 0.248*** (41.68) Yes No No 66,310 0.056 66,310 0.388 66,310 0.044 0.099*** Notes: This table presents estimation results from regressing firms’ cash effective tax rates on Internal Revenue Service (IRS) audit rates and controls Unreported industry controls are based on the Fama and French (1997) industry classification Beneath each coefficient estimate is reported the t-statistic based on robust standard errors adjusted for clustering by firm The superscripts asterisks ***, **, and * denote two-tailed statistical significance at the 1%, 5%, and 10% levels, respectively ASSET DECILES are indicator variables (unreported) representing the deciles in assets TREND is a linear trend variable, with 1992 equal to 1, 1993 equal to and so on TREND2 is the linear trend variable, squared All other variables are defined in the notes to Table 2, and in Appendix 48 Table Corporate Tax Avoidance and IRS Monitoring – Sensitivity Analysis Alternative IRS Enforcement Excluding CIC Alternative Tax Avoidance Measures NON-CONFORMING AUDIT PROBABILITY 3-YEAR CASH CASH ETR ETR (1) Dependant Variable: Firms Measures (2) (3) 0.092*** (4.44) 0.040** (2.13) 0.109*** (8.26) CASH ETR GAAP ETR IV Estimation Lag AUDIT Lag CASH PROBABILITY ETR CASH ETR (5) CASH ETR CASH ETR CASH ETR (6) (7) (8) (9) (10) 0.262*** (3.86) (4) 1.731*** (11.87) 0.073*** (4.22) 0.038*** (2.76) 0.125*** (8.88) 0.003*** (3.67) -0.095*** (-22.59) 0.049*** (7.11) -0.301*** (-12.70) -0.072*** (-5.68) -0.117*** (-9.64) -0.064*** (-25.71) 0.128*** (8.24) -0.025 (-0.61) 0.021*** (7.09) 0.288*** (32.59) Yes Yes 66,310 0.1931 0.580** (2.17) DISTRICT/TIME AUDIT PROBABILITY 0.004** (2.53) -0.079*** (-12.62) -0.002* (-1.66) -0.064*** (-9.55) 0.007*** (7.19) -0.012*** (-2.58) 0.006*** (4.87) -0.082*** (-12.61) 0.008*** (7.95) -0.081*** (-12.49) 0.015*** (4.79) -0.068*** (-9.00) -0.076*** (-10.94) -0.118*** (-21.89) -0.003** (-2.32) -0.085*** (-12.92) 0.313*** (40.86) -0.003*** (-2.97) -0.063*** (-12.12) 0.327*** (21.85) -0.370*** (-10.20) -0.161*** (-9.63) 0.717*** (33.23) -0.061*** (-17.20) 0.218*** (12.06) -0.126* (-1.89) 0.007 (1.43) 0.182*** (15.22) Yes Yes 59,205 0.165 0.096*** (9.28) -0.275*** (-6.85) -0.088*** (-5.33) 0.091*** (5.27) -0.043*** (-11.57) 0.085*** (4.51) 0.005 (0.09) 0.008* (1.83) 0.372*** (28.03) Yes Yes 47,087 0.081 0.010 (1.56) -0.242*** (-8.53) 0.043*** (3.86) 0.015 (1.05) -0.024*** (-8.97) 0.168*** (11.23) -0.213*** (-4.90) 0.018*** (5.50) 0.254*** (34.89) Yes Yes 62,531 0.091 0.032*** (3.27) -0.342*** (-9.52) -0.057*** (-3.66) -0.117*** (-6.23) -0.072*** (-16.71) 0.109*** (5.36) -0.188*** (-2.94) 0.027*** (5.14) 0.303*** (22.86) Yes Yes 37,631 0.066 0.031*** (3.23) -0.351*** (-9.72) -0.058*** (-3.73) -0.118*** (-6.25) -0.072*** (-16.73) 0.110*** (5.39) -0.186*** (-2.92) 0.026*** (5.06) 0.289*** (18.84) Yes Yes 37,631 0.066 0.022** (2.15) -0.299*** (-8.00) -0.043*** (-2.58) -0.139*** (-7.17) -0.087*** (-18.45) 0.067*** (3.98) -0.006 (-0.06) 0.002 (0.32) 0.210*** (9.89) Yes Yes 29,914 0.080 0.071*** (9.37) -0.268*** (-11.39) -0.052*** (-4.12) -0.141*** (-11.72) -0.054*** (-21.87) 0.070*** (4.49) -0.216*** (-5.01) 0.014*** (4.73) 0.077*** (3.30) Yes Yes 66,310 0.059*** (6.07) -0.286*** (-8.10) -0.089*** (-5.42) -0.162*** (-8.97) -0.051*** (-14.78) 0.183*** (9.30) -0.134*** (-2.62) 0.013*** (3.07) 0.327*** (27.20) Yes Yes 51,684 0.070 0.050*** (6.67) -0.175*** (-6.16) -0.046*** (-3.51) -0.155*** (-10.45) -0.036*** (-13.16) 0.124*** (7.16) -0.156*** (-4.08) 0.009*** (2.76) 0.231*** (23.84) Yes Yes 51,684 0.153 Lagged CASH ETR LEVERAGE INVENTORY INTENSITY R&D INTENSITY CAPITAL EXPENDITURE ROA NOL ΔNOL FOREIGN INCOME BIG FOUR Constant Year Fixed Effects Industry Fixed Effects Observations R-squared CASH ETR 0.034*** (3.39) DISTRICT/SIZE/TIME AUDIT PROBABILITY Log(ASSETS) TOBIT preprint accepted manuscript Notes: This table presents estimation results from regressing firms’ effective tax rates on Internal Revenue Service (IRS) audit rates and controls Unreported industry controls are based on the Fama and French (1997) industry classification Beneath each coefficient estimate is reported the t-statistic based on robust standard errors adjusted for clustering by firm The superscripts asterisks ***, **, and * denote two-tailed statistical significance at the 1%, 5%, and 10% levels, respectively All variables are defined in the notes to Table 2, and in Appendix 49 Table Examples of Audit Probabilities for selected years and asset sizes for two IRS Districts, and the percentage differences between the two districts Return Type/Asset Class Percent of Returns Audited - Pennsylvania District Fiscal Year 2000 < $250,000 Assets $1 Million < $5 Million Assets $5 Million < $10 Million Assets $50 Million < $100 Million Assets $250 Million Assets or more Return Type/Asset Class 1998 1996 1994 1992 0.33% 0.86% 1.22% 0.89% 1.13% 1.06% 4.35% 7.10% 7.34% 6.24% 2.14% 8.04% 16.63% 19.16% 16.27% 10.31% 22.19% 28.82% 36.62% 27.78% 22.85% 30.96% 42.73% 48.53% 44.60% Percent of Returns Audited - Rocky Mountain District Fiscal Year 2000 < $250,000 Assets $1 Million < $5 Million Assets $5 Million < $10 Million Assets $50 Million < $100 Million Assets $250 Million Assets or more Return Type/Asset Class 1998 1996 1994 1992 0.26% 0.48% 0.69% 0.66% 1.76% 1.80% 3.94% 3.89% 5.54% 10.26% 4.66% 8.35% 9.75% 14.64% 19.73% 8.48% 12.08% 19.05% 21.58% 33.33% 28.20% 28.64% 36.47% 57.64% 90.27% Percentage Difference Between Pennsylvania and the Rocky Fiscal Year 2000 < $250,000 Assets $1 Million < $5 Million Assets $5 Million < $10 Million Assets $50 Million < $100 Million Assets $250 Million Assets or more 1998 1996 1994 1992 21.21% -69.81% -117.76% 17.75% -23.41% 44.19% 9.43% -3.86% 45.56% 7.49% 43.44% 45.21% 41.37% 33.90% 14.65% 25.84% 24.52% 23.59% 41.07% -18.77% -55.75% -64.42% -21.27% -19.98% -102.40% preprint accepted manuscript Notes: These data are taken from the Transactional Records Access Clearinghouse TracFed database They are representative examples of the Audit Probabilities in two different districts, and the percentage difference between those districts 50 Table Corporate Tax Avoidance and IRS Monitoring – the Role of Firm-level Governance Governance Variable: INSTITUTIONAL DEDICATED INSTITUTIONAL HIGH G-INDEX G-INDEX BIG FOUR (1) (2) (3) (4) (5) AUDIT PROBABILITY 0.095** 0.002 0.186*** 0.149*** 0.131*** (2.57) (0.02) (7.18) (7.59) (7.40) GOVERNANCE -0.030* -0.007** 0.037*** 0.041*** 0.240*** (-1.88) (-2.19) (5.60) (3.67) (5.72) AUDIT PROBABILITY * GOVERNANCE 0.078** 0.019** -0.096*** -0.148*** -0.646*** (-5.14) HOLDINGS HOLDINGS (2.03) INVENTORY INTENSITY (-4.20) (-4.78) -0.005** 0.001 0.001 0.001 (-2.40) (0.86) (0.69) (0.53) -0.065*** -0.096*** -0.078*** -0.079*** -0.079*** (-4.60) LEVERAGE (2.43) -0.007*** (-3.48) Log(ASSETS) (-6.70) (-14.13) (-14.27) (-14.15) 0.038* 0.041* 0.034*** 0.035*** 0.035*** (1.73) (1.88) (4.06) (4.16) (4.17) R&D INTENSITY -0.310*** -0.251*** -0.299*** -0.298*** -0.303*** (-4.61) (-3.61) (-9.69) (-9.69) (-9.81) CAPITAL EXPENDITURES -0.182*** -0.186*** -0.079*** -0.078*** -0.078*** (-5.24) (-4.69) (-5.73) (-5.61) (-5.64) ROA -0.122*** -0.110*** -0.139*** -0.140*** -0.143*** (-3.68) (-2.94) (-8.97) (-8.98) (-9.21) NOL -0.029*** -0.024*** -0.057*** -0.057*** -0.057*** ΔNOL (-4.90) 0.204*** (-4.11) 0.061 (-18.07) 0.113*** (-18.05) 0.114*** (-18.13) 0.113*** (4.07) (1.02) (7.73) (7.79) (7.74) FOREIGN INCOME -0.152** (-2.10) -0.118 (-1.61) -0.062 (-1.24) -0.051 (-1.01) -0.059 (-1.18) BIG FOUR 0.012 (1.17) 0.366*** (11.02) Yes Yes 14,585 0.065 0.009 (0.82) 0.480*** (7.49) Yes Yes 8,943 0.084 0.016*** (4.04) 0.302*** (27.28) Yes Yes 66,310 0.068 0.015*** (3.95) 0.311*** (29.33) Yes Yes 66,310 0.068 Constant Year Fixed Effects Industry Fixed Effects Observations R-squared preprint 0.298*** (25.59) Yes Yes 66,310 0.067 accepted manuscript Notes: This table presents estimation results from regressing firms’ effective tax rates on Internal Revenue Service (IRS) audit rates, firm-level governance, and controls Unreported industry controls are based on the Fama and French (1997) industry classification Beneath each coefficient estimate is reported the t-statistic based on robust standard errors adjusted for clustering by firm The superscripts asterisks ***, **, and * denote two-tailed statistical significance at the 1%, 5%, and 10% levels, respectively HIGH G-INDEX is an indicator variable coded if the firm has an above median value of the Gompers Index Score for firm i in 1998 G-INDEX is the Gompers Index Score for firm i in year t BIG FOUR is an indicator variable coded one if the firm was audited by a Big Four auditor in year t, and zero otherwise INSTITUTIONAL HOLDINGS is the portion of the firm held by institutional investors in year t DEDICATED INSTITUTIONAL HOLDINGS is the portion of the firm held by dedicated institutional investors in year t All other variables are defined in the notes to Table 2, and in Appendix 51 ... PROBABILITY 0. 15 0.1 0. 05 -0. 05 q5 q10 q 15 q20 q 25 q30 q 35 q40 q 45 q50 q 55 q60 q 65 q70 q 75 q80 q 85 q90 q 95 -0.1 -0. 15 -0.2 -0. 25 Quantile Coefficient on AUDIT PROBABILITY Lower 95th Percentile... 874 776 6 65 5 65 479 480 481 55 2 51 0 4 85 436 386 10339 1449 155 8 1783 1876 2078 21 45 2107 20 95 20 35 18 45 1931 2 058 2777 2843 2873 2 654 2289 36396 preprint accepted manuscript Total 37 65 4016 4407... 8 95 922 900 987 842 629 56 4 453 373 359 349 370 329 293 261 227 959 3 $1 - $5 Million $5 - $10 Million 50 7 54 1 604 611 6 45 607 53 7 438 337 286 274 251 269 242 212 189 179 6729 59 3 6 75 769 761 852