Does public scrutiny on corporate tax decisions affect directors? Effects of responsible (irresponsible) corporate tax practices on director reputation

Abstract

In 2004, the Citizens of Tax Justice (CTJ) released a report that significantly raised public awareness of corporate tax avoidance practices in the companies that it scrutinised in the study. Using a six-year period straddling the CTJ event, we compare over time changes in external board seats held by incumbent directors serving scrutinised firms against those of their counterparts serving control firms with comparable tax practices but that were not scrutinised in the CTJ study. Incumbent directors in scrutinised firms with minimal tax avoidance practices gained more external board seats after the CTJ event than did board members in control firms. However, directors in scrutinised firms with aggressive tax avoidance practices neither gained nor lost more external board seats after the CTJ event than did directors in control firms. These findings provide little evidence that constituents in the corporate sector overwhelmingly favour tax minimisation practices as acceptable practices of conducting business operations. Rather, they provide evidence that corporate constituents, like their social peers, are somewhat attuned to the expectation for socially responsible tax practices. Lastly, we find that directors in scruitised firms with minimal tax avoidance practices are more likely to gain board seats from like-minded firms with responsible tax practices.

Keywords:

• Corporate tax avoidance
• news media coverage
• director reputation
• corporate social responsibility
• social norm
• labour market for directors

Acknowledgement

The paper benefitted greatly from valuable comments and suggestions of an anonymous referee and the associate editor (Martin Jacob). We thank our respective institutions for the financial support and our colleagues for their comments. Qiang Wu thank The Hong Kong Polytechnic University for research support through the start-up fund (1-BE52).

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 Hanlon and Slemrod (2009) and Gallemore, Maydew, and Thornock (2014) use stock price reactions to news that reveal corporate tax shelters to measure reputation effects on firms accused of undertaking aggressive tax avoidance. Their results indicate a small decline in stock price surrounding the announcement period of the news, but the decline reverses in 30 days. Additionally, Gallemore, Maydew, and Thornock (2014) find that tax shelter revelations do not significantly affect the likelihood of executive turnover. Li, Shevlin, and Zhang (2022) argue that career-related reputation cost of tax avoidance decisions for managers could be low. Chyz and Gaertner (2017) and Lanis, Richardson, Liu, and McClure (2019) use corporate tax rates to measure the tax decisions. Their findings indicate that shareholders penalise their own executives for engaging in aggressive tax avoidance practices, but these decision makers tend to gain additional external board seats.

2 Studies that examine the reputation effects of both corporate tax practices in the same setting have typically used corporate tax rates to measure the tax decisions (Chyz and Gaertner, 2017; Lanis, Richardson, Liu, and McClure, 2019). However, this empirical design does not suit our analysis because it does not isolate the reputation effects arising from public scrutiny on corporate tax decisions.

3 Prior studies find that the public scrutiny from news medias has a significant influence on managerial behavior and capital markets (Miller, 2006; Blankespoor et al., 2018; Chang et al., 2022; Heese et al., 2022).

4 Lanis, Richardson, Liu, and McClure (2019) draw the inference from regressions that relate the levels of corporate tax avoidance activities to changes in decision makers’ reputation. In contrast, we employ an empirical setting that provides an estimate of the reputation effects associated with news and the attendant increase in public scrutiny on corporate tax decisions. This is advantageous because the news event is arguably exogenous, which means that endogeneity and self-selection are less likely to plague our estimations. Additionally, we employ six matching criteria to identify control firms. In the end, we have treatment and control firms with similar tax decision, tax risk, firm size, accounting-based and stock-based firm performance, and tax loss carry forward. Gallemore, Maydew, and Thornock (2014) also use a matched control sample, but their matching criteria include neither tax decision nor tax risk.

5 Public awareness and public scrutiny of corporate tax decisions have increased significantly over the recent years. Accordingly, it is plausible that one would observe more prominent reputation effects associated with news of minimal tax avoidance practices (aggressive tax avoidance practices) in today’s environment.

6 Additionally, we find the same result using two other proxies for corporate visibility and reputation. These proxies are brand capital (Belo, Lin, and Vitorino, 2014) and Fortune magazine’s scores for ‘Most Admired Companies,’ following Flanagan and O’Shaughnessy (2005). For brevity, we do not tabulate these results.

7 We note that there are downward trends in director reputation in the post-event period, during 2004–2007, except for the treatment firms in the responsible taxpayer sample. This is consistent with the conjecture that the CTJ scrutiny increased the reputation of directors in the treatment firms in the responsible taxpayer sample, which, in turn, mitigated the contemporaneous negative effect on a director’s number of board seats arising from the Sarbanes-Oxley Act (SOX) of 2002 due to increased directors’ workload and risk. Overall, the downward trend may create a bias against finding the results in the responsible taxpayer sample.

8 Our results are also robust to an alternative sampling procedure. Our regression samples are based on a categorization method that groups the 170 matched pairs into three subsamples using the treatment firm’s average tax rate in the 2001–2003 period reported in the CTJ study. Specifically, we use quartile to operationalise this sampling procedure. In the robustness check, we use terciles to define firms with minimal and aggressive tax avoidance practices. Our results are qualitatively unchanged if we use tercile to operationalise the sampling procedure. For brevity, we do not tabulate these results.

9 Our main findings also help to advance our understanding of the ‘under-sheltering puzzle’ (Weisbach, 2002; Desai and Dharmapala, 2006; Hanlon and Heitzman, 2010; Hasan, Hoi, Wu, and Zhang, 2014), which refers to the observation that many firms appear to pay higher taxes than their peers by foregoing valuable tax planning opportunities. Nevertheless, we acknowledge that many firms still engage in tax avoidance despite positive reputational effects of minimum tax avoidance practices on directors, which our findings cannot explain.