Risk and Return: Does Tax Risk Reduce Firms’ Effective Tax Rates?
Posted: 14 Feb 2013
Date Written: February 11, 2013
This study develops an ex-ante measure of firms’ overall tax risk, allowing us to classify a firm as pursuing a more or less risky tax strategy relative to other firms, and examines the distribution of tax outcomes associated with levels of tax risk. Our study is important because tax practitioners and firms have begun to focus on managing tax risk to improve the expected outcomes of firms’ tax strategies, but researchers have not systematically measured ex-ante tax risk or its association with tax outcomes. Our results indicate that tax risk is negatively associated with future cash effective tax rates; however, the sustainability of a firm’s pretax earnings moderates this association. Relative to other firms, firms with sustainable or unsustainable pretax earnings pay significantly higher taxes for an equal increase in tax risk. Our results imply that firms earn returns for tax risk, but that return depends on nontax considerations.
Keywords: tax risk, uncertain tax strategies, effective tax rates
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