Managerial ability and tax avoidance: evidence from Korea

Abstract

This study investigates the incremental effects of managerial ability on tax avoidance. Managerial ability is estimated through a data envelopment analysis (DEA) and tobit regressions. We find that there is a negative relationship between tax avoidance and firm value. In addition, we document a statistically meaningful negative relation between managerial ability and tax avoidance. The results also suggest that high managerial ability mitigates the negative relationship between tax avoidance and firm value. These findings suggest that managerial ability influences the tax avoidance behavior of the firm.

Keywords:

• managerial ability
• tax avoidance
• firm value
• data envelopment analysis

JEL Classifications:

• M14
• M40

Acknowledgement

This paper is based on the second chapter of corresponding author's Ph.D dissertation.

Notes

1. Since there are no measures that can accurately capture tax avoidance, all tax avoidance measures have relative limitations (Ko, Yoon, et al. 2013). Therefore, the results of empirically implementing various tax avoidance measures were additionally analyzed, and the results are presented in “5.4.2 Alternative Measurement of Tax Avoidance.”

2. In this research, tax burden is tax expenses in income statement plus (minus) deferred tax asset (liability). The estimated taxable income is calculated as follows .

3. Managerial ability could also affect the variables attributed to the firm. We take on the side of attributing manager characteristics to the firm, to maximize the likelihood that the residual is largely attributable to the manager (Demerjian, Lev, and McVay 2012).

4. As Tobin’s Q is used as a dependent variable, the natural log of total sales is used as firm size to avoid spurious correlations.

5. KLCA is as a non-profit association consisting of companies listed on the KRX (as issuers of stock certificates). It develops and maintains TS200, a database that includes financial statement information.

6. Demerjian, Lev, and McVay (2012) explain this with Jack Welch of GE as an example. GE’s total firm efficiency is expected to be 1. However, since GE’s firm size, market share, and business operation period should be high, low values will be derived for manager ability measures that correspond to the residuals after controlling these from the firm’s efficiency. That is, low values will be derived for Jack Welch’s managerial ability. If the firm’s characteristics variables such as firm size are removed from the control variables of regression analysis formulas for measuring managerial ability, high values will be derived for Jack Welch’s managerial ability as with general expectations. A recent previous study conducted by Demerjian, Lev, and McVay (2012) using MA also reported significant negative correlations between MA and SIZE (Francis, Sun, and Wu 2013; Koester, Shelvin, and Wangerin 2013).

7. The instrument variable should satisfy two conditions. One is that the instrument variable should be correlated with the endogenous variable. The other is that the instrument variable should be independent with error term of the regression. According to this research analysis, BTD has a very high correlation with tax avoidance. In addition, BTD has a very low correlation with firm value. However, the coefficient of BTD is not statistically significant in the multiple regression analysis of BTD and firm value. Therefore, BTD is selected as an instrument variable.

8. Using lagged information in the main regression can partially mitigate potential endogeneity issues. This is implemented by including the lagged dependent variable for the control variable in the main regression (Hoi, Wu, and Zhang 2013, TAR). As the result of the tests that include the lagged dependent variable as the control variable in the main regression, we find similar results that support the negative relationship between managerial ability and tax avoidance.

9. In this study, tax paid is calculated by adding deferred income tax assets and subtracting deferred income tax liabilities from income tax paid (Shim 2011).