How Prevalent is Tax Arbitrage? Evidence from the Market for Municipal Bonds

Although tax arbitrage is central to the literatures on tax capitalization, implicit taxes, and even capital structure, there is little empirical evidence of the extent to which firms actually engage in tax arbitrage. This paper provides some evidence on the topic by focusing on a simple and observable corporate arbitrage strategy in the market for municipal bonds. It poses a puzzle for the literature, however, in that we find little evidence of municipal bond tax arbitrage by non-financial corporations. The overwhelming majority of firms are not engaging in the arbitrage at all and even among those engaged in arbitrage, many firms do less than a safe-harbor amount allowed by the tax authorities. Such a pattern is consistent with the presence of both fixed and marginal (i.e., that depend on size of the position) costs of arbitrage, though we cannot observe what those costs are.

The Changing Role of Auditors in Corporate Tax Planning

This paper examines changes in the role that auditors play in corporate tax planning following recent events, including the well-known accounting scandals, passage of the Sarbanes-Oxley Act, and regulatory actions by the SEC and PCAOB. On the whole, these events have increased the sensitivity to and scrutiny of auditor independence. We examine the effects of these events on the market for tax planning, in particular the longstanding link between audit and tax services. While the effects are recent, they are already being seen in the data. Specifically, there has already been a dramatic shift in the market for tax planning away from obtaining tax planning services from one's auditor. We estimate that the ratio of tax fees to audit fees paid to the auditors of firms in the S&P 500 decline from approximately one in 2001 to one-fourth in 2004. At the same time, we find no evidence of a general decline in spending for tax services. In sum, the evidence indicates a decoupling of the longstanding link between audit and tax services, such that firms are shifting their purchase of tax services away from their auditor and towards other providers.

Capital Gains Taxes and Asset Prices: Capitalization or Lock-In?

This paper examines the impact on asset prices from a reduction in the long-term capital gains tax rate using an equilibrium approach that considers both demand and supply responses. We demonstrate that the equilibrium impact of capital gains taxes reflects both the capitalization effect (i.e., capital gains taxes decrease demand) and the lock-in effect (i.e., capital gains taxes decrease supply). Depending on time periods and stock characteristics, either effect may dominate. Using the Taxpayer Relief Act of 1997 as our event, we find evidence supporting a dominant capitalization effect in the week following news that sharply increased the probability of a reduction in the capital gains tax rate and a dominant lock-in effect in the week after the rate reduction became effective. Nondividend paying stocks (whose shareholders only face capital gains taxes) experience higher average returns during the week the capitalization effect dominates and stocks with large embedded capital gains and high tax sensitive investor ownership exhibit lower average returns during the week the lock-in effect dominates. We also find that the tax cut increases the trading volume during the week immediately before and after the tax cut becomes effective and in stocks with large embedded capital gains and high tax sensitive ownership during the dominant lock-in week.

Taking the Long Way Home: U.S. Tax Evasion and Offshore Investments in U.S. Equity and Debt Markets

We empirically investigate one form of illegal investor-level tax evasion and its effect on foreign portfolio investment. In particular, we examine a form of round-tripping tax evasion in which U.S. individuals hide funds in entities located in offshore tax havens and then invest those funds in U.S. securities markets. Employing Becker's (1968) economic theory of crime, we identify the tax evasion component by examining how foreign portfolio investment varies with changes in the incentives to evade and the risks of detection. To our knowledge, this is the first empirical evidence of investor-level tax evasion affecting cross-border equity and debt investment

Coveting Thy Neighbor's Manuafacturing: The Dilemma of State Income Apportionment

This paper investigates the economic impact of the apportionment formulae used to divide corporate income taxes among the states. Most apportionment formulae, by including payroll, turn the state corporate income tax at least partially into a payroll tax. Using panel data from 1978 - 1994, the results show that this distortion has an important effect on state-level employment. For the average state, reducing the payroll weight from one-third to one-quarter increases manufacturing employment around 3% and the result is highly robust. The results also indicate that apportionment changes have important negative externalities on other states in that the effects of the apportionment formula on aggregate employment is zero. Every job gained within a state from an apportionment change is taken from another state. This externality suggests that the U.S. would be better off if the apportionment formula were set at a federal level. The paper also shows that because the payroll component of the tax is administered on top of the existing payroll tax, the deadweight loss from this component of state corporate income taxation may be significant, despite the low tax rates.

Taking the Long Way Home: U.S. Tax Evasion and Offshore Investments in U.S. Equity and Debt Markets

We empirically investigate one form of illegal investor-level tax evasion and its effect on foreign portfolio investment. In particular, we examine a form of round-tripping tax evasion in which U.S. individuals hide funds in entities located in offshore tax havens and then invest those funds in U.S. securities markets. Employing Becker’s (1968) economic theory of crime, we identify the tax evasion component in foreign portfolio investment data by examining how foreign portfolio investment varies with changes in the incentives to evade and the risks of detection. To our knowledge, this is the first empirical evidence of investor-level tax evasion affecting cross-border investment in equity and debt markets

Where do firms manage earnings?

Despite decades of research on how, why, and when companies manage earnings, there is a paucity of evidence about the geographic location of earnings management within multinational firms. In this study, we examine where companies manage earnings using a sample of 2,067 U.S. multinational firms from 1994-2009. We predict and find that firms with extensive foreign operations in weak rule of law countries have more foreign earnings management than companies with subsidiaries in locations where the rule of law is strong. We also find some evidence that profitable firms with extensive tax haven subsidiaries manage earnings more than other firms, and that the earnings management is concentrated in foreign income. Apart from these results, we find that most earnings management takes place in domestic income, not foreign income

Customer-Supplier Relationships and Corporate Tax Avoidance

ABSTRACT We find that close customer-supplier relationships facilitate tax avoidance by both principal customers and their dependent suppliers. We investigate two mechanisms by which firms in these relationships avoid taxes. First, we find evidence that principal customers engage in a tax strategy involving centralized procurement by tax haven subsidiaries. Second, we find that close customer-supplier relationships promote the diffusion of tax avoidance knowledge from principal customers, who tend to be relatively large and sophisticated, to their dependent suppliers, who tend to be smaller and less sophisticated. Our study provides evidence of the importance of tax avoidance as a source of gains from these relationships. JEL Classification: H25, H26, L1