Conforming Tax Avoidance and Capital Market Pressure

Abstract

In this study we develop a measure of corporate tax avoidance that reduces both financial and taxable income, which we refer to as “book-tax conforming” tax avoidance. We use LIFO/FIFO inventory method conversions, as well as samples of private and public firms, to validate our measure of conforming tax avoidance. We then investigate the prevalence of conforming tax avoidance within a sample of public firms. Results from the validation tests indicate that our measure of conforming tax avoidance successfully captures book-tax conforming transactions and thus, variation in conforming tax avoidance at private and public firms. Consistent with expectations, we also find that the extent to which public firms engage in conforming tax avoidance varies systematically with the capital market pressures to which they are subject. For example, public firms that lack analyst following, do not issue equity securities, report lower sales growth, or smaller discretionary accruals engage in relatively more conforming tax avoidance and less nonconforming tax avoidance. Our study develops a new measure of conforming tax avoidance that should be useful in future research and it provides new insights on the extent to which public firms are willing to reduce income tax liabilities at the expense of reporting lower financial income.