How Reliably Do Empirical Tests Identify Tax Avoidance?
46 Pages Posted: 6 Dec 2014 Last revised: 30 Nov 2018
Date Written: May 2, 2018
Can common empirical tests reliably identify tax avoidance? This is an important question because our understanding of the determinants of tax avoidance largely depends on results generated using such tests. We address this question by using a controlled environment to evaluate the relative power of commonly-used empirical tests of tax avoidance. We seed Compustat data with three tax avoidance strategies and examine how reliably empirical tests using different tax avoidance proxies identify this simulated tax avoidance. We find that power varies with the proxy and the type of tax avoidance. Thus, we offer guidance to researchers in matching specific types of tax avoidance with the most powerful test to detect it. We further offer evidence on how research design choices including sample selection and skewness correction affect the power of tests. Results suggest researchers can increase power by eliminating observations with both negative pre-tax book income and negative tax expense, and by using robust regression to address skewness in the data. In contrast, power is impaired when truncating ETR proxies and when estimating tests on small samples.
Keywords: tax avoidance, effective tax rates, book-tax differences, simulated data
JEL Classification: H25, H26, M41
Suggested Citation: Suggested Citation