December 14, 2017
CONTACTBen Hamowitz (718-398-7642)

CEOs are at risk not only if their firms pay a lot more tax than peers but also if they pay a lot less, study finds

SOX has increased public sensitivity to corporate tax aggressiveness

What to make of the fact that proposals for federal tax reform, highly touted though they are, have attracted as little as 25% approval in recent polls? Perhaps it is because their most salient feature is a sharp cut in the U.S. corporate tax rate, even as a large swath of the public believes too many companies do not pay their fair share of taxes.

Past research has offered mixed evidence on whether they do or do not: it has found that, despite the existence of a 35% statutory levy, federal tax rates vary considerably from one firm to another, as corporations navigate in myriad ways the intricacies of the Internal Revenue code. Now some new scholarship provides hints on how currently proposed corporate tax reforms, featuring a cut in the statutory rate from 35% to 21%, will affect this situation.

The paper, in the January issue of the American Accounting Association journal The Accounting Review, is the first to present evidence that CEOs put their jobs at risk when their companies are a lot less taxed than peer firms. It also finds that this state of affairs is fairly recent, dating from about the passage of the Sarbanes-Oxley law (SOX).

Enacted in 2002 in response to jolting financial scandals at Enron, WorldCom and other major companies, SOX instituted a considerable tightening of federal corporate regulation. In the words of the study, by James A. Chyz of the University of Tennessee and Fabio B. Gaertner of the University of Wisconsin–Madison, the “post-SOX period coincided with increased IRS scrutiny of aggressive tax positions and legislation that led to increased regulatory scrutiny over the tax function. Consistent with increased pressures to be less tax-aggressive, we find that being in the lowest quintile of benchmarked tax rates [became] influential in predicting CEO turnover… This is consistent with boards responding to…increase[d] political and reputational costs surrounding tax avoidance.”

With SOX and various regulatory and judicial initiatives having raised public sensitivity to companies’ tax-aggressiveness, the professors surmise that the sharply reduced statutory rate currently proposed in Washington would likely inhibit it still further. They reason that, if tax-aggressiveness wreaks damage on companies’ standings when the statutory rate is 35%, as their study suggests, it would likely cause even more reputational and political damage at 21%, since aggressive tax maneuverings would be perceived as less justifiable.

The study’s findings are based on an analysis of the relationship between year-by-year tax rates of about 5,100 public companies during a 14-year period and the incidence of forced turnover of those firms’ CEOs. For every year the researchers 1) calculated each firm’s three-year tax rate (the aggregate tax for that year and the two previous years divided by aggregate three-year income) and 2) computed a benchmarked measure of that rate (how it compared with the rates of firms of about the same size in the same industry). Finally, they investigated whether there was a significant relationship those benchmarked measures and concomitant forced CEO departures.

As expected, firms exhibited great variation in tax rates. For example, when the study’s full 30,000 firm-years’ worth of data was divided into five groups based on benchmarked tax rates, the companies in the lowest quintile had a mean effective rate about 20 percentage points lower than the average for peer firms, while companies in the highest quintile had a rate about 20 percentage points higher than their peers’. In the 14 years covered by the paper (which included years preceding and subsequent to the enactment of SOX), the 5,108 companies constituting the study sample had 1,459 forced CEO turnovers.

Controlling for a whole slew of factors that can affect such forced turnovers, the researchers unsurprisingly find CEOs to be at increased risk when their company tax rates are high. “Because taxes represent a wealth transfer from shareholders to government authorities, CEOs are more likely to be terminated when their firms pay high taxes,” the professors write, noting also that “boards not only focus on effective tax rates but also regularly compare these rates to those of their peers.” Indeed, the study finds that firms in the highest tax quintile (highest taxed relative to peers) have forced turnover rates about 20% higher than the average for the three middle quintiles. The general pattern prevails during pre-SOX and post-SOX years alike.

Where the study breaks important new ground is in showing increased likelihood of CEO turnover when company tax rates are low. Thus, firms in the lowest tax quintile are, on average, about 15% more likely to have forced CEO turnovers than companies in the middle three quintiles. Yet, if the analysis is restricted to the years before SOX, there is no significant difference in forced turnovers; in contrast, the authors write, “the effect is positive and significant in the post-SOX period consistent with the predicted effect of regulatory changes and an increased scrutiny on the corporate tax function.”

To test the robustness of their findings, Chyz and Gaertner carry out analyses of the relationship between company taxes and unforced CEO turnovers (such as through death, illness, and planned retirement). They find no statistical relationship between the two, reinforcing the conclusion that both high and low company taxes do, indeed, evoke board disapproval.

Finally, they investigate changes in tax avoidance as new CEOs take the reins in firms that had relatively high or low tax rates just prior to the predecessor’s forced departure. They find that replacement CEOs move rates closer to those of their peers.

The study, entitled "Can Paying ‘Too Much’ or ‘Too Little’ Tax Contribute to Forced CEO Turnover?" is in the January 2018 issue of The Accounting Review, published six times yearly by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Auditing: A Journal of Practice and Theory, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, Journal of Financial Reporting, The Journal of the American Taxation Association, and Journal of Forensic Accounting Research.