What determines ETRs? The relative influence of tax and other factors

Abstract

Many studies use GAAP effective tax rates (ETRs) as a proxy for tax avoidance and assume that very low (high) ETRs represent the greatest (least) tax avoidance. Using income tax footnote disclosures from 2008 through 2016, we investigate how well ETRs capture cross-sectional differences in tax avoidance versus other factors. We document that ETRs below 5% and above 40% are significantly influenced by items largely unrelated to tax avoidance such as valuation allowances and goodwill impairments. Truncating ETRs at zero and one, controlling for standard determinants of tax avoidance, and using industry-size-adjusted ETRs or multi-year GAAP ETRs do not eliminate the clustering of factors largely unrelated to tax avoidance in the tails of the distribution. Cash ETRs attenuate but do not eliminate this clustering. Researchers can use ETR rate reconciliation data to construct an adjusted ETR that removes the influence of factors largely unrelated to tax avoidance. Our findings inform researchers about factors largely unrelated to tax avoidance that drive significant deviations in ETRs from the statutory tax rate. This is of increasing importance as the number of studies examining the consequences of very high and very low ETRs grows.

Keywords: Tax avoidance, effective tax rate, valuation allowance, goodwill impairments, FIN 48