The Benefits of Uncertainty: Uncertain Tax Strategies and Implicit Taxes

Abstract

Economic theory suggests that tax-favored strategies attract investment, and this increased investment demand offsets tax benefits through lower pre-tax returns (i.e., implicit taxes). We propose that aggressive strategies that generate uncertain tax benefits have lower demand due to both the concern that the tax authority will overturn these uncertain strategies upon audit and because the firm does not receive the full benefit of the strategies on its financial statements. Consistent with this, we find that firms’ investment in uncertain tax positions, holding cash effective tax rates constant, is associated with lower implicit taxes (i.e., higher pre-tax earnings and firm value). Subsequent analysis using exogenous variation in IRS enforcement supports the audit mechanism and helps mitigate concerns about reverse causality. Lower implicit taxes also arise, in part, from the earnings effects of uncertain tax positions, supporting the financial reporting mechanism. Our results illustrate a non-tax benefit of uncertain tax strategies.

Keywords: Implicit Taxes, Tax Avoidance, Uncertain Tax Positions

JEL Classification: G32, H25, M4