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How Reliably Do Empirical Tests Identify Tax Avoidance?

48 Pages Posted: 6 Dec 2014 Last revised: 7 Aug 2017

Lisa De Simone

Stanford Graduate School of Business

Jordan Nickerson

Boston College

Jeri K. Seidman

University of Virginia - McIntire School of Commerce

Bridget Stomberg

Indiana University

Date Written: June 27, 2017

Abstract

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 examine the effectiveness of empirical tests that use effective tax rates (ETR) and book-tax differences (BTD) as tax avoidance proxies. We seed Compustat data with three tax avoidance strategies and examine how reliably empirical tests identify this incremental simulated tax avoidance, all else equal. 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 proxy to detect it. We further offer evidence on how research design choices affect power. 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 data outliers. In contrast, power is impaired when truncating ETR proxies and when using Execucomp data. We also provide evidence that tests have less power to detect tax avoidance when multi-year ETR proxies are used.

Keywords: tax avoidance, skewness bias, effective tax rate, book-tax difference

JEL Classification: C150, H25, H26, M41

Suggested Citation

De Simone, Lisa and Nickerson, Jordan and Seidman, Jeri K. and Stomberg, Bridget, How Reliably Do Empirical Tests Identify Tax Avoidance? (June 27, 2017). Rock Center for Corporate Governance at Stanford University Working Paper No. 200; Stanford University Graduate School of Business Research Paper No. 15-5. Available at SSRN: https://ssrn.com/abstract=2534058 or http://dx.doi.org/10.2139/ssrn.2534058

Lisa De Simone

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-723-3874 (Phone)
650-724-3083 (Fax)

HOME PAGE: http://www.gsb.stanford.edu/faculty-research/faculty/lisa-de-simone

Jordan Nickerson

Boston College ( email )

Carroll School of Management
140 Commonwealth Avenue
Chestnut Hill, MA 02467-3808
United States

Jeri K. Seidman (Contact Author)

University of Virginia - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States

Bridget Stomberg

Indiana University ( email )

107 S Indiana Ave
100 South Woodlawn
Bloomington, IN 47405
United States

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