Taxes and Financial Constraints: Evidence from Linguistic Cues
53 Pages Posted: 30 Jun 2014 Last revised: 20 Jul 2015
Date Written: March 2, 2015
Using a new measure of financial constraints based on firms’ qualitative disclosures, we find that financially constrained firms — firms that use more negative words in their annual reports — pursue more aggressive tax planning strategies as evidenced by: (1) higher current and future unrecognized tax benefits, (2) lower short- and long-run current and future effective tax rates, (3) increase in tax haven usage for their material operations, and (4) higher proposed audit adjustments from the Internal Revenue Service. We exploit the unexpected closures of local banks as exogenous liquidity shocks to show that firms’ external financial constraints affect their tax avoidance strategies. Overall, the linguistic cues in firms’ qualitative disclosures provide incremental information beyond traditional accounting variables or commonly used effective tax rates to reveal and predict tax aggressiveness, both contemporaneously and in the future.
Keywords: Tax Avoidance, Unrecognized Tax Reserve, Negative Words, Disclosure
JEL Classification: H25, H26, M41, G30
Suggested Citation: Suggested Citation