Determinants of the variability in corporate effective tax rates and tax reform: Evidence from Australia PDF

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Available online at www.sciencedirect.com Journal of Accounting and Public Policy 26 (2007) 689–704 www.elsevier.com/locate/jaccpubpol Determinants of the variability in corporate effective tax rates and tax reform: Evidence from Australia a,* b Grant Richardson , Roman Lanis a Department of Accounta...

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Determinants of the variability in corporate effective tax rates and tax reform: Evidence from Australia Grant Richardson Journal of Accounting and Public Policy

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Available online at www.sciencedirect.com

Journal of Accounting and Public Policy 26 (2007) 689–704 www.elsevier.com/locate/jaccpubpol

Determinants of the variability in corporate effective tax rates and tax reform: Evidence from Australia Grant Richardson

a,*

, Roman Lanis

b

a

Department of Accountancy, Faculty of Business, City University of Hong Kong, 83 Tat Chee Avenue, Kowloon Tong, Hong Kong, People’s Republic of China b School of Accounting, Faculty of Business, University of Technology – Sydney, Cnr of Quay Street and Ultimo Road, Haymarket, Sydney, NSW 2000, Australia

Abstract This study examines the determinants of the variability in corporate effective tax rates in Australia spanning the Ralph Review of Business Taxation reform. Our results indicate that corporate effective tax rates are associated with several major firm-specific characteristics, including firm size, capital structure (leverage) and asset mix (capital intensity, inventory intensity and R&D intensity). While the Ralph Review tax reform had a significant impact on many of these associations, corporate effective tax rates continue to be associated with firm size, capital structure and asset mix after the tax reform. Ó 2007 Elsevier Inc. All rights reserved. Keywords: Corporate effective tax rates; Ralph Review tax reform; Size; Capital structure; Asset mix

*

Corresponding author.Tel.: +86 2788 7923; fax: +86 2788 7944. E-mail address: [email protected] (G. Richardson).

0278-4254/$ - see front matter Ó 2007 Elsevier Inc. All rights reserved. doi:10.1016/j.jaccpubpol.2007.10.003

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1. Introduction Corporate effective tax rates (ETRs)1 are often used by policy-makers and interest groups as a tool to make inferences about corporate tax systems because they provide a convenient summary statistic of the cumulative effect of various tax incentive and corporate tax rate changes (Kern and Morris, 1992, p. 81; Gupta and Newberry, 1997, p. 1). Evidence in the US has shown that ETRs vary across firms and over time, which suggested that the corporate tax system was inequitable and so was used as a major justification for tax reform (Shevlin and Porter, 1992, p. 60). However, there is a lack of research on ETRs and tax reform, especially in countries outside the US. A potential reason for the lack of research in this area is that corporate tax reform is infrequent; hence the opportunity for undertaking such research is limited. The Ralph Review of Business Taxation represented a major event in corporate tax reform in Australia (Cooper et al., 2002, p. 20; Gilders et al., 2004, p. 16). The Ralph Review was given a mandate by the Australian Government to broadly assess the adequacy of the country’s business income tax policy (Ralph, 1999, p. 10). It submitted its proposals to the Australian Government on July 30, 1999. Several of the Ralph Review’s key proposals could affect the characteristics normally associated with ETRs. Accelerated depreciation was recommended for removal. Moreover, a phased-in reduction of the corporate tax rate was also suggested. The Australian Government accepted these key proposals, and they were codified in the Income Tax Assessment Act (1997), with application from the 1999–2000 tax year. The Ralph Review tax reform provides a unique opportunity to treat this important tax policy event as a natural experiment for examining the determinants of the variability in corporate ETRs in Australia spanning the tax reform. In so doing, our study adds to the sparse literature about ETRs and tax reform. Moreover, our results provide some further insights into ETRs that should be useful to policy-makers. We investigate the impact of firm size, capital structure (leverage) and asset mix (capital intensity, inventory intensity and R&D intensity) on ETRs covering the Ralph Review. Formal tests of the impact of the tax reform on these associations and whether ETRs are associated with these characteristics after the tax reform are also considered. 1 There are many different types of corporate ETRs in the literature (see, e.g. Plesko, 2003, p. 206). Distinctions are made between average ETRs and marginal ETRs. Average ETRs are defined as tax liability divided by income, while marginal ETRs are defined as the change in tax for a given change in income. The suitability of each type depends on a study’s research question. Average ETRs are appropriate to examine the distribution of tax burdens across firms or industries, while marginal ETRs are suitable to analyze the incentives of new investments (Gupta and Newberry, 1997, p. 1). This study uses the term ETRs to denote average effective tax rates, and two different measures are used to improve the robustness of our results: income tax expense divided by book income and income tax expense divided by operating cash flows.

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We present evidence that shows a significant negative association between ETRs and firm size. We also find that ETRs have a significant negative association with capital structure in terms of leverage. A significant negative (positive) association is also observed between ETRs and asset mix for capital intensity and R&D intensity (inventory intensity). While the Ralph Review had a major impact on many of these associations, ETRs are still associated with firm size, capital structure and asset mix following the tax reform. The remainder of the paper is organized as follows. Section 2 reviews the major determinants of ETRs and develops hypotheses. Section 3 describes the research design. Section 4 reports and analyzes the results. Finally, Section 5 concludes.

2. Determinants of ETRs and hypotheses 2.1. ETRs and firm size There are two competing views about the association between ETRs and firm size: the political cost theory and the political power theory. Specifically, under the political cost theory, the higher visibility of larger and more prosperous firms causes them to become victims of greater regulatory actions by government and wealth transfers (Watts and Zimmerman, 1986, p. 235). As taxes are one part of the total political costs borne by firms, this theory claims that larger firms have higher ETRs (Zimmerman, 1983, p. 119). The alternative view under the political power theory is that larger firms have lower ETRs because they have substantial resources available to them to manipulate the political process in their favor, engage in tax-planning and organize their activities to achieve optimal tax savings (Siegfried, 1972, pp. 32–36). Studies of US firms on the association between ETRs and firm size have produced conflicting results. While Zimmerman (1983) finds a positive association between ETRs and firm size, Porcano (1986) observes a negative association between these variables. Finally, based on empirical evidence, Gupta and Newberry (1997, p. 28) assert that the inconsistent results suggest that firm-size effects could be sample-specific and not likely to exist over time in firms with longer histories. Australian research on ETRs and firm size is almost non-existent. Tran (1997, p. 529), however, observes a negative association between ETRs and firm size. In another study undertaken to identify the causes of this negative association, Tran (1998, p. 282) finds that larger firms benefited more from tax-planning (tax incentives) than smaller firms. We therefore expect a negative association between ETRs and firm size in our study. Finally, we also test the validity of Gupta and Newberry’s (1997, p. 28) assertion that firm-size effects might be sample-specific and unlikely to exist over time in firms with longer histories, using Australian data.

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2.2. ETRs and firms’ financing and investment decisions Firms’ financing decisions could impact on ETRs because tax statutes normally allow differential tax treatment to the capital structure decisions of firms (Gupta and Newberry, 1997, p. 7). Consider, for example, the situation in which a firm relies more heavily on debt financing rather than equity financing to support its business operations. Given that interest expenditure is tax deductible while dividends are not, firms with higher leverage are expected to have lower ETRs. Research by Stickney and McGee (1982) and Gupta and Newberry (1997) finds a negative association between ETRs and leverage. Firms’ investment decisions might also impact on ETRs. As tax statutes usually permit taxpayers to write-off the cost of depreciable assets over periods shorter than their economic lives; firms that are more capital-intensive are expected to have lower ETRs (Stickney and McGee, 1982, p. 142). To the extent that inventory intensity is a substitute for capital intensity, inventoryintensive firms should possess higher ETRs (Zimmerman, 1983, p. 130). Gupta and Newberry (1997) provide evidence that firms with a larger proportion of fixed assets have lower ETRs due to tax incentives, while firms with a greater proportion of inventory have higher ETRs. Finally, R&D expenditure furnishes an investment tax shield for R&D-intensive firms. This suggests a negative association with ETRs (Gupta and Newberry, 1997, p. 15). Following from the above discussion, we hypothesize that: H1: H2: H3: H4: H5:

ETRs ETRs ETRs ETRs ETRs

are are are are are

negatively associated with firm size. negatively associated with firm leverage. negatively associated with firm capital intensity. positively associated with firm inventory intensity. negatively associated with firm R&D intensity.

2.3. ETRs and tax reform We also investigate whether the Ralph Review tax reform had an effect on ETRs, and if it impacted on the associations between ETRs and variables reflecting the outcomes of firms’ financing and investment decisions. The key Ralph Review tax-reform proposals are summarized in Table 1, along with their estimated corporate tax revenue impacts over the period 1999–2005. Table 1 shows that several of the tax reforms were designed to increase corporate tax revenue, so they should be considered base-broadening tax reforms. The replacement of accelerated depreciation with an effective life depreciation regime was the most important base-broadening tax reform. High-level tax design reforms, such as the removal of the 13-month prepayment rule that previously allowed firms to claim tax deductions in advance, are the next most

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Table 1 Estimated effects of the Ralph Review tax reform on corporate tax revenues over the period 1999– 2005 (AUD$Billions)

Tax reforms increasing corporate tax revenue Removal of accelerated depreciation High-level tax design reforms Changes to the taxation of investments Integrity measures Capital gains tax reforms Tax reforms decreasing corporate tax revenue Reduction in corporate tax rates Changes to the taxation of income from entities Small business measures Net corporate tax revenue impact

AUD$B

AUD$B

10.87 .97 .89 .53 .23

13.49

(14.45) (2.02) (2.01)

(18.48) (4.99)

Source: Ralph (1999, p. 698).

important base-broadening tax reform. Finally, changes to the taxation of investments, such as the removal of taxation on the profit on sale of depreciable assets, integrity measures that restricted the use of unrealized losses for firms and capital gains tax reforms which removed asset indexation were also intended to be base-broadening. Table 1 also illustrates that several of the tax reforms were designed to decrease corporate tax revenue. The phased-in reduction of the corporate tax rate for the 2000–2001 tax year (from 36% to 34%), and for the 2001–2002 tax year and thereafter (from 34% to 30%) was the most important tax reform measure designed to decrease corporate tax revenue. The remaining tax reform measures were estimated to have a negative impact on tax revenue. These include changes to the taxation of income from business entities, such as refunding dividend imputation credits, and small business measures, such as allowing cash accounting. On the basis of the tax revenue estimates summarized in Table 1, the overall impact of the Ralph Review tax reform is expected to cause a net reduction in corporate tax revenue for the Australian Government of AUD$4.99 billion. Hence, the tax reform is expected to have a significant negative association with ETRs. It is also possible that the Ralph Review tax reform impacted on the associations between ETRs and variables reflecting the outcomes of firms’ financing and investment decisions. In terms of financing, where firms rely more heavily on debt financing in their capital structure, this is expected to increase ETRs after the tax reform, as the reduction in the corporate tax rate decreases the tax savings on interest. For investment, where firms are capital-intensive, this is also expected to increase ETRs after the tax reform, due to the removal of accelerated depreciation and a reduction in the corporate tax rate. To the

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extent that inventory intensity is a substitute for capital intensity, inventoryintensive firms should have lower ETRs after the tax reform. Finally, the Ralph Review proposed no change in tax policy for the R&D tax concession, so the tax reform is not expected to have an impact on the association between ETRs and R&D expenditure. Following from the above discussion, we hypothesize that: H6: ETRs are negatively associated with the Ralph Review tax reform. H7: The association between ETRs and firm leverage is positively impacted upon by the Ralph Review tax reform. H8: The association between ETRs and firm capital intensity is positively impacted upon by the Ralph Review tax reform. H9: The association between ETRs and firm inventory intensity is negatively impacted upon by the Ralph Review tax reform. H10: The association between ETRs and firm R&D expenditure is not impacted upon by the Ralph Review tax reform. 3. Research design 3.1. Sample and data Our sample consists of a single panel of publicly-listed Australian firms collected from the Aspect Financial Database over the period 1997–2003. However, the year 2000 was excluded because this is a transitional tax year in terms of the Ralph Review proposals, and prior research (e.g. Dhaliwal and Wang, 1992; Scholes et al., 1992; Guenther, 1994) shows that firms normally respond to tax legislation changes one year after tax legislation becomes operative. The final sample consists of 92 firms (552 firm years) after excluding firms that fall into the following categories: (a) Financial firms, since government regulation faced by these firms is likely to affect their ETRs differently from other firms. (b) Foreign firms, as these firms’ financing and investment decisions may be impacted upon by resident country tax laws that differ from Australian tax laws. (c) Firms with missing data and/or no activity firms. (d) Firms with negative income or tax refunds, since their ETRs are distorted (e.g. Zimmerman, 1983; Omer et al., 1993). (e) Firms that have NOL carry-forwards because their ETRs are difficult to interpret (e.g. Wang, 1991) and are not included in traditional ETR research (e.g. Wilkie and Limberg, 1993). (f) Firms with ETRs exceeding one, since this can cause model estimation problems (e.g. Stickney and McGee, 1982; Gupta and Newberry, 1997).

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Table 2 Sample reconciliation 1997–1999 and 2001–2003a All firms in the Aspect Financial Database excluding financial institutions and foreign firms Less: Firms with missing data and/or no activity Firms with negative income or tax refunds Firms with NOL carry-forwards Firms with ETRs exceeding one Final sample (number of firms) Final sample (firm years) a

1529

(1347) (56) (13) (21) 92 552

The year 2000 was excluded from the sample.

A summary of the sample reconciliation is presented in Table 2. 3.2. Dependent variable The dependent variable is represented by ETRs. In conventional research, ETRs are measured based on information collected from financial statements as tax liability divided by income. However, the appropriate definitions of both the numerator and the denominator of this equation are open to debate (e.g. Shevlin and Porter, 1992; Wilkie and Limberg, 1993; Plesko, 2003). The issue of which taxes to include in the numerator of the equation is relevant because any significant omission can bias the overall tax burdens of firms. Some researchers (e.g. Porcano, 1986; Gupta and Newberry, 1997) use the income tax expense of firms and make no adjustment for deferred tax expense. Others (e.g. Stickney and McGee, 1982; Omer et al., 1993) argue for an adjustment to income tax expense by subtracting the deferred tax expense portion. Income tax expense is used as the numerator of our equation without any deferred tax adjustment, since Australian firms are not required to report deferred tax expense in their financial statements under Accounting Standard AASB 1020: Accounting for Income Tax (Tax-Effect Accounting). The issue of how income should be measured in the denominator of the equation arises due to the difference between accounting (book) income and taxable income. The choices include taxable income, book income and cash flow from operations. Taxable income should not be used if the purpose of a study is to capture the impact of tax incentives on ETRs. If both the numerator (income tax expense) and the denominator (income) are after tax incentives, then any systematic variation in ETRs because of tax incentives will not be detected (Gupta and Newberry, 1997, p. 12). We use book income as the primary income measure in the denominator. Cash flow from operations is used

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as an alternative measure, as this controls for systematic differences in accounting method choices that are related to firm size (Zimmerman, 1983, p. 123). In short, two different measures of ETRs are employed as the dependent variable to improve the robustness of our results. The first (ETR1) is defined as income tax expense divided by book income. The second (ETR2) is defined as income tax expense divided by operating cash flows. 3.3. Independent variables 3.3.1. Firm-specific variables Firm-specific variables are denoted by proxies for firm size, capital structure (financing) and asset mix (investing). Firm size (SIZE) is measured as the natural logarithm of total assets (at book value). Financial leverage (LEV) is included to proxy for firms’ capital structure, and is measured as the long-term debt divided by total assets (both at book values). Three independent variables are included in the study to proxy for firms’ asset mix: capital intensity (CINT), inventory intensity (INVINT) and R&D intensity (RDINT). Specifically, CINT is measured as the net prope...