How Do Firms Use Cash Tax Savings: A Cross-Country Analysis

Abstract

Avoiding cash taxes can serve as a significant source of additional cash flows for firms, though how managers utilize these funds and the resulting consequences remain open empirical questions. We provide answers by examining the association between the amount of cash tax savings and two uses of cash -investment and dividend payout -for an international sample of firms. We find that firms are more likely to invest cash tax savings rather than distribute them in the form of dividends and that this results in inefficient overinvestment. We find that our results hold for an international sample of domestic-only firms, distinguishing our study from US-only studies, which focus on constraints and distortions of multinational corporations in a worldwide tax system. We find nuanced results when partitioning on country-level governance. Our results suggest cash tax avoidance has real effects on firm decisions, namely investment and payout policies, and this effect varies based on the country in which the firm operates.JEL classifications: M41, H20, G31, G30 Investment:Invest The sum of research and development expenditures, capital expenditures and acquisitions less dispositions of property plant and equipment, deflated by total assets in t-1 (Biddle et al. 2009). absInvestEff The absolute value of the error term from a regression of Invest on the percentage change in sales (Biddle et al. 2009). CapExCapital expenditures less dispositions of property plant and equipment, deflated by total assets in t-1. Non-CapExThe sum of research and development expenditures and acquisitions, deflated by total assets in t-1. IntangiblesIntangibles deflated by total assets in t-1. DivPay:CashDiv Cash dividends paid scaled by total assets in year t. PayoutDividends less gain/loss on the sale of stock scaled by lagged total assets. Cash Tax Savings: CTSThe country's statutory tax rate less the cash effective tax rate (computed as cash taxes paid divided by pre-tax income). CTS is set to missing if pretax income is negative. Governance: LowGovIndicator variable set equal to one if the firm is located in a country in the lowest tercile of Bushman, Piotroski and Smith (2004) governance index. Control Variables:CloseShares Closely-held shares at t divided by total shares outstanding at t. AQAccrual quality, based on Dechow and Dichev (2002) and Biddle et al. (2009), computed as -1 times the standard deviation of the residual (from t-5 to t-1) obtained from regressing a change in working capital on cash from operations in t+1, cash from operations in t, cash from operations in t-1, change in revenue, and property plant and equipment, with all variables scaled by total assets in t-1. The model is estimated by country, industry and year, provided the country-industry-year has 10 or more observations. σCFO Standard deviation, computed from year t-5 to year t-1, of cash flow from operations scaled by total assets in t-1. Does investment efficiency improve after the disclosure of material weaknesses in internal control over financial reporting? Jou...

Tax Avoidance and Asymmetric Cost Behavior

“…Building on Edwards et al (2016), Guenther et al (2017) find that firms with high (low) financial constraints use relatively less (more) cash tax savings for real investment compared with other cash flows. Using a sample of international firms, Green and Kerr (2016) find that firms are more likely to use cash tax savings for investment, rather than for dividend payout. Our study is closely related to these studies.…”

“…As resource allocation is a part of investment decisions, our study adds to the literature on taxes and investment in particular (Hanlon & Heitzman, 2010). 1 More importantly, recent literature on tax avoidance begins to investigate the effect of tax avoidance on firms’ investment decisions (e.g., Edwards et al, 2016; Green & Kerr, 2016; Guenther, Njoroge, & Williams, 2017). Our study is closely related to this line of literature.…”

Empirical evidence on the impact of recent Korean tax reforms

“…Blanchard et al (1994) find that firms are likely to overinvest funds from cash tax savings based on volatile tax avoidance. Using multinational data, Green and Kerr (2016) show that firms' tax avoidance activities affect firms' decisions such as investment and dividend payout. They examine how cash tax savings are associated with cash investments and dividend payouts and find that the firms with greater cash tax avoidance are more likely to fund investment rather than paying out them in the form of dividends.…”

“…One way in which financially constrained firms have been found to generate additional funds for R&D (and other investments) is through tax avoidance behavior (Blaylock, 2016;Green & Kerr, 2016), despite the risk of being audited by tax authorities (Desai & Dharmapala, 2006;Rego, 2003;Slemrod, 2001;Ayers et al, 2011;Edwards et al, 2013;Brondolo, 2009;Campello et al, 2011Campello et al, , 2012) 2 . Such increased R&D investment in turn may increase the firm's market value (Ayers et al, 2011).…”

Allocation of Internal Cash Flow when Firms Pay Less Tax

“…Prior research has focused on one important source of tax-related cashtax avoidanceand has often examined one use of tax-related cash at a time. This literature has found a positive association between tax avoidance and investment (Chen and Lai 2012;Mayberry 2012;Edwards, Schwab, and Shevlin 2016;Green and Kerr 2016;Goldman 2017), acquisitions (Hanlon, Lester, and Verdi 2015;Edwards, Kravet, and Wilson 2016), cash savings (Hanlon, Maydew, and Saavadra 2017), and shareholder payouts (Blouin and Krull 2009). However, these findings do not address the question of whether firms simply use the tax-related cash to do more of everything, and these studies do not compare the use of tax-related cash to that of other after-tax cash flow.…”