Examining the Association between Tax Risk and Tax Outcomes

Abstract

This study develops and validates an ex-ante measure of firm-specific overall tax risk. We define tax risk as the potential that current actions or activities, or the failure to take actions or pursue activities, will lead to future tax outcomes that are different from expectations. Tax risk arises from the interaction of economic risk and tax law uncertainty. An ex-ante measure of firm-specific tax risk allows us to classify firms as pursuing a more or less risky tax strategy relative to other firms. Our study is important because revenue authorities worldwide have increased their scrutiny of firms engaging in risky tax strategies and greater tax risk can impact the economic performance of firms’ investments. Tax practitioners and their clients engage in tax risk management to improve the expected outcomes of firm-specific tax strategies; however, researchers have not measured ex-ante tax risk or its association with tax outcomes. Our results document an association between our measure of tax risk and other measures of firm risk found in both the accounting and finance literatures. We also find a negative association between tax risk and cash effective tax rates, implying that, on average, firms manage tax risk effectively and earn returns (in the form of lower cash taxes paid) for engaging in higher tax risk. Thus, our results contribute to the ongoing discussion of corporate tax avoidance, as well as provide a replicable measure of firm-specific tax risk that researchers can use to examine questions about corporate tax avoidance more broadly.

Keywords: tax risk, uncertain tax strategies, effective tax rates, tax outcomes

JEL Classification: M40, M41, M49, G18, G32, H25, H32, K20