Abstract

While prior literature examines the role of certain incentives in motivating top managers (CEOs and CFOs) to engage in corporate tax avoidance, there is little evidence on the specific actions that managers take in response to these incentives. Motivated by the premise that a manager can influence a firm’s tax activities by directing resources towards the tax function, I investigate whether four specific tax avoidance incentives studied in prior literature (financial constraints, equity risk incentives, hedge fund interventions, and analyst cash flow forecasts) induce managers to make investments in hiring personnel within the firm’s tax department. Using a dataset of tax department employees collected from the professional networking website LinkedIn, I find evidence that each incentive is significantly associated with an increase in the number of individuals employed within the tax department. This association is generally stronger among higher ranked employees and employees with prior tax department experience. Overall, my findings are consistent with the premise that managers invest resources in the tax function when they are incentivized to avoid taxes. My study also provides some assurance that the association between tax avoidance incentives and effective tax rates documented in prior studies is reflective of intentional tax avoidance behavior.

Introduction

A large subset of the tax avoidance literature examines incentives that motivate top managers (CEOs and CFOs) to engage in corporate tax avoidance. The most common empirical approach in these studies is to examine the relationship between a specific incentive and tax planning outcomes of the firm, such as effective tax rates (ETRs). However, one drawback of this approach is that it provides no evidence regarding the specific actions that managers take in response to these incentives. Managers are unlikely to involve themselves directly in developing or implementing tax strategies given that they are rarely tax experts. Instead, the literature argues that they have a ‘tone at the top’ effect on the firm’s tax activities, which includes emphasizing the tax function when allocating resources across different functional areas of the firm (e.g. (Dyreng et al., 2010). Therefore, while prior studies focus on how tax avoidance incentives relate to outputs of the tax function (e.g. cash tax savings), managers will likely respond to these incentives by allocating resources to increase inputs into the tax function. Empirically, establishing an association between tax avoidance incentives and tax function inputs will provide stronger evidence regarding the effectiveness of these incentives. However, while tax function outputs are observable through publicly available financial statements, inputs are more difficult to measure.

In this study, I directly examine the relationship between tax avoidance incentives and inputs into the tax function – i.e. tax function investments. While investments in the tax function can be measured in different ways, I focus specifically on the quantity of tax personnel hired in the tax department. Indeed, (Mills et al., 1998) highlight that most tax function resources are allocated towards tax department personnel as opposed to outside assistance. The quantity of tax personnel hired is likely the most direct method of measuring tax department investments, has been shown in prior literature to be effective in generating tax savings (e.g. Chen et al., 2021, Barrios and Gallemore, 2023), and is publicly available through analyzing data from the professional networking website LinkedIn.

Conclusion

In this study, I examine whether managers respond to tax avoidance incentives by increasing investments made in the firm’s tax function, using the quantity of tax personnel employed as my primary measure. Using four types of incentives examined in prior literature – financial constraints, equity risk incentives, hedge fund interventions and analyst cash flow forecasts, and using a dataset of tax department employees collected from the professional networking website LinkedIn, I find that the quantity of tax personnel employed by the firm increases with each of the four incentives. My results are consistent with prior literature suggesting that managerial influence over firm tax planning is limited to ‘tone at the top’ effects, such as their ability to invest resources into the tax function.

Overall, my study complements prior literature examining these tax avoidance incentives by highlighting how inputs of the tax function respond to these incentives, in contrast with prior studies that only focus on outputs of the tax function (i.e. tax savings). The intuitive appeal of this approach is that it directly links these incentives with a specific managerial action, rather than the outcomes of these actions. The common definition of an ‘incentive’ involves the incitement of action and effort. However, since tax avoidance is not an area that managers generally specialize in, it is unlikely that managers exert effort personally in the development and execution of tax strategies. The results of my study suggest that the ‘action and effort’ incited by these incentives may be observable through an increase in tax personnel hiring, an indication that managers are allocating additional resources towards the tax function. Future researchers examining tax avoidance incentives may wish to strengthen their results by demonstrating, in conjunction with improved tax avoidance outcomes, that their incentive measure is related to an increase in tax function investments.