Intriguing patterns of declining effective tax rates among U.S. firms emerged from 1996 to 2015, prompting questions about the underlying reasons behind this trend. TCU Neeley School of Business Professor Stephen Lusch in partnership with an expert team embarked on a pioneering research endeavor to determine the cause, and in doing so transform our understanding of tax strategies in the corporate world.
September 11, 2023
By Neeley Analytics Initiative
Stephen Lusch, associate professor of accounting and the academic director of Neeley Fellows, conducted a research project investigating the source of declining effective tax rates for corporations from 1996 to 2015. This research led to Lusch publishing an article along with Katharine D. Drake with the University of Arizona and Russ Hamilton with Southern Methodist University. The article, "Are declining effective tax rates indicative of tax avoidance? Insight from effective tax rate reconciliations" is published in the Journal of Accounting and Economics.
The declining trend in effective tax rates had been identified by prior research and the media; however, questions about the trend remained. Is this indicative of intentional tax avoidance behavior evolving over time? What factors drive effective tax rates, and how can we accurately measure tax avoidance?
Specifically, Lusch and the research team found that tax avoidance is frequently assessed by comparing effective tax rates (ETRs) across different companies and time periods. By analyzing the detailed tax footnote data of companies, they discovered that the inclusion of valuation allowances (VA) associated with previous losses distorts the effective tax rates calculated under Generally Accepted Accounting Principles (GAAP). Additionally, they observed that valuation allowances are responsible for variations in effective tax rates not only between domestic firms but also between multinational firms.
This bias also affects cash effective tax rates and other tax avoidance measures commonly used in academic research. To address this issue, the research team developed a methodology that substantially reduces the bias in analyzing both cash and GAAP effective tax rates in both longitudinal and comparative studies. This methodology led them to believe that much of the decline in effective tax rates over time, particularly for companies with only U.S. operations, is due to the financial accounting effects of valuation allowances.
“Overall, I believe our study has raised awareness among researchers about the effects that companies’ loss histories have on effective tax rates and the inferences we make about tax avoidance behavior among these firms” said Lusch.
Lusch and the team’s findings suggest that firms' past loss experiences and GAAP regulations have a considerable impact on the interpretations drawn from tax avoidance indicators. In the future, Lusch believes that there is an opportunity for researchers to develop higher quality proxies for tax avoidance that more cleanly capture the construct that is trying to be measured. Furthermore, he hopes that this research will change literature going forward on whether or not tax avoidance is being measured appropriately.